Risk Management in International Trade Finance
120
1 A PROJECT REPORT ON RISK MANAGEMENT IN INTERNATIONAL TRADE FINANCE AT UNION BANK OF INDIA (OVERSEAS BRANCH, NARIMAN POINT, MUMBAI) BY CHIRAG SHAH ISFS/MSF/07/M/0024 ICFAI SCHOOL OF FINANCIAL STUDIES MUMBAI
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This is my 100 marks project report (report completed under Union Bank of India). Happy Learning !!!
Transcript of Risk Management in International Trade Finance
1
A PROJECT REPORT ON
RISK MANAGEMENT IN
INTERNATIONAL TRADE FINANCE
AT
UNION BANK OF INDIA
(OVERSEAS BRANCH, NARIMAN POINT,
MUMBAI)
BY
CHIRAG SHAH
ISFS/MSF/07/M/0024
ICFAI SCHOOL OF FINANCIAL STUDIESMUMBAI
2
RISK MANAGEMENT IN INTERNATIONALTRADE FINANCE
BY
CHIRAG SHAH
ISFS/MSF/07/M/0024
CHHAYA DANGDA(Faculty Guide)
A Report Submitted in Partial Fulfillment of
the Requirement of MS (Finance) Program
of ISFS 2007-09
3
DECLARATION
The project work carried out by me and presented through this report under
the title “RISK MANAGEMENT IN INTERNATIONAL TRADE FINANCE” is
an original one and has not been copied from elsewhere and has not been
submitted elsewhere.
Date: Signature
Roll no. ISFS 0024
4
5
ACKNOWLEDGEMENT
On the onset I take the privilege to convey my gratitude to those who have
cooperated, supported, helped and suggested me to accomplish my project
work. This project work bears imprint, of many persons who are either directly
or indirectly involved in the completion of it.
I am grateful to Mr. R. Rengarajan, Center Head, ISFS Mumbai who has
given me an opportunity to pursue my Summer Internship project in Union
bank of India.
I am also desirous of placing a record profound indebtness to my Faculty
guide Prof. Chhaya Dangda, ISFS, Mumbai and my Company guide Mr. P Y
Kotkar for his valuable advice, inputs, guidance, precious time and support
they offered.
I would also like to thank:
Mr. Ajit Kulkarni (CGM, Overseas Branch, UBI)
Mr. Girish Dave (Asst. Manager, Overseas Branch, UBI)
Mr. Kiran Shah (Asst. Manager, Overseas Branch, UBI)
Mr. P.D.Talekar (Senior Manager, Dept. of Agri Business, UBI)
for explaining various intricacies related to International Trade Finance.
Lastly, I convey my heartfelt thanks to the entire staff of UBI, Overseas
Branch, Nariman Point, for their co-operation during my project work.
I want to also thank my friends, colleagues and parents who have directly or
indirectly helped me out in the completion of my project.
CHIRAG SHAH
ISFS 0024
6
Executive summary
Risk management in banking designates the entire set of risk management
processes and models allowing banks to implement risk-based policies and
practices. They cover all techniques and management tools required for measuring,
monitoring and controlling risks. The spectrum of models and processes extends to
all risks: credit risk, market risk, interest rate risk, liquidity risk and operational risk, to
mention only major areas. Broadly speaking, risk designates any uncertainty that
might trigger losses. Risk-based policies and practices have a common goal:
enhancing the risk–return profile of the bank portfolio. The innovation in this area is
the gradual extension of new quantified risk measures to all categories of risks,
providing new views on risks, in addition to qualitative indicators of risks.
Current risks are tomorrow’s potential losses. Still, they are not as visible as tangible
revenues and costs are. Risk measurement is a conceptual and a practical
challenge, which probably explains why risk management suffered from a lack of
credible measures. The recent period has seen the emergence of a number of
models and of ‘risk management tools’ for quantifying and monitoring risks. Such
tools enhance considerably the views on risks and provide the ability to control them.
Now, talking about Risk management in International Trade Finance, it has got
considerable importance these days because of the following reasons:-
Sub prime crisis in USA leading to extreme exchange rate fluctuations:
01/08/2006 – Rs. 46.65/$
07/11/2007 – Rs. 39.27/$
16/07/2008 – Rs. 43.17/$
7
Oil Price Shock:
Feb 2008 – $135.55/bbl
July 2006 - $ 95.15/bbl
11.91% inflation for the week ended 05/07/2008
Sometimes it is very tough for RBI to control inflation because the cause of it is not in
its hands i.e. oil price shock (reaching $145.17/bbl). It is evident from the steps that
are not materializing taken by RBI such as increasing the MSS slab, raising CRR to
8.75%, raising Repo rate to 8.50% and other special market operations due to which
it had to encourage fiscal steps such as free import custom duties, ban on certain
export products, ban on certain export future contracts, etc.
This leads trouble for both the Indian Banks and the exporters. The banks raise rates
of advances due to the above steps taken by the RBI and the exporters have to
suffer losses due to the exchange rate appreciation (volatility has increased a lot).
So, to study the above risks in international trade finance plus how it is controlled is
my objective of doing this project.
This project considers and includes various departments like Export, Import,
Advances, and Guarantees and the risk management tools used for
hedging its exposure.
Due to RBI’s steps, interest rates have become very volatile, so a study is
included about the interest rate volatility and its impact on profitability of
the bank through a GAP analysis.
8
As any bank in this world faces default risk, a study is included about how
the banks quantify and reduce such credit risk (a credit rating model is used
in this chapter to find out its effectiveness).
In addition an effort is made to find out can ALTMAN’s Z – SCORE MODEL
for public listed companies can be INDIANSED or not? For which a sample of
30 companies have been considered which have already defaulted and their
financial results of past years have been used to find out whether it can be
known that the company is going to default or not?
Another characteristic of this project report is that after every chapter it
concludes with a Value Added Note (VAN) which explains various basic
terms included in the chapter and current scenario changes that have taken
place and its implications on Indian Banks Trade finance department.
9
RISK MANAGEMENT IN INTERNATIONAL TRADE FINANCE
INDEX
Sr. no.
Chapters Page no.
1. Risk & its types
Introduction
Types of Risks
Value Added Notes (VAN) – Types of Exposure in Forex
13
13
14
22
2. Risk Management in Banking
Risk Management
RBI guidelines
Need of Risk Management in Banks
Risk Control Measures
VAN – FEDAI Guidelines for Foreign Exchange
24
24
26
28
30
31
3. International Trade Finance
Introduction to International Trade
Current Scenario of India’s International Trade
India’s BoP position
UBI & its Overseas Branch
Incoterms 2000
International Trade Documents involved
VAN – LERMS
33
34
35
38
39
41
44
52
10
4. Risk Management in Import Advances
Introduction
Letter of Credit (L/C)
How the L/C operates?
Parties to an L/C
Types of L/C
Risk associated with opening Import L/Cs
Risk Management Tools used – Documents involved
Forward Contracts
UBI’s Export Import Performance
VAN – Capital Account Convertibility of Indian Rupee
53
53
54
54
55
56
57
58
62
66
67
5. Risk Management in Export Finance
Pre shipment Finance
Features of Pre shipment finance
Types of Pre shipment finance
Post shipment finance
Features of Post shipment finance
Types of Post shipment Finance
Risk Management tools used – WTPCG scheme
Forward Purchase Contract
SWAPs
VAN – Relief to Exporters for a while?
68
68
68
69
71
71
72
74
76
77
82
11
6. Risk Management in issuing Guarantees
Introduction
Benefits of Bank Guarantees
Types of Bank Guarantees
How to apply for Bank Guarantees
Bank Guarantee V/s. L/C
UBI – An overview of issued L/C & L/G
Risk Management Tools used
VAN – How the Importers use Buyer’s Credit for their
own Advantage?
83
83
84
84
86
87
87
88
90
7. Risk Management in Granting Advances
Introduction
Credit Rating Model
Calculating Loan Amount
VAN – Format of evaluation of Companies followed
before granting a loan
92
92
94
101
101
8. Interest Rate volatility and its impact on Profitability – GAP Analysis
Why interest rates are so volatile in India?
GAP analysis
Observations
Generalizations
Suggestions
Outcome
VAN – Deposit rates of Indian banks – a comparative study
102
102
103
105
105
106
106
107
12
9. Indianising Altman’s Z score Model – A study
Introduction
A short Z score History
Z score Ingredients
Z score Original Model
Objective of the study
Study Method
Data Source
Analysis of the study
Findings
Problem faced
Criticisms
Outcome
108
108
109
110
111
112
112
113
113
114
114
115
116
Conclusion 117
References 119
13
Chapter 1
Risk & its Types
Risk is a concept that denotes a potential negative impact to some characteristic of
value that may arise from a future event. Exposure to the consequences of
uncertainty constitutes a risk. In everyday usage, risk is often used synonymously
with the probability of a known loss. (Definition from dictionary: The possibility of
suffering harm or loss; danger.)
Risk can be explained as an uncertainty and is usually associated with the
unpredictability of an investment performance. All investments are subject to risk, but
some have a greater degree of risk than others. Risk is often viewed as the potential
for an investment to decrease in value.
Though quantitative analysis plays a significant role, experience, market knowledge
and judgment play a key role in proper risk management. As complexity of Financial
Products increased, so do the sophistication of the Risk Manager’s tools.
We understand risk as a potential future loss. When we take an insurance cover,
what we are hedging is the uncertainty associated with the future events. Financial
risk can be easily stated as the potential for future cash flows (returns) to deviate
from expected cash flows (returns).
“Risk is the only constant,Uncertainty is the only certainty.”
14
TYPES OF RISKS:
Identifying and classifying risk types are critical components of a fully functional risk
and capital management framework. Board and senior management may not be able
to efficiently perform risk management activities without clearly defined risk
categories that are aligned with business needs. In parallel, certain bottom-up risk
management analytical activities require guidance to appropriately identify measure,
monitor and report key individual risks.
Banking Risks
Liquidity
Interest rate
Foreign Exchange
Operations
Credit
Market
Other risks: Country Risk, Settlement Risk, Performance Risk, etc.
15
Risks borne by banks:
Liquidity Risk
Liquidity risk is the potential inability of a bank to generate sufficient cash to meet its
normal operating requirements (cash expenses and repayment of short term
liabilities). A mismatch in the assets and liabilities causes a bank to have a liquidity
risk. A bank often promises greater liquidity in its liabilities than its assets can provide
directly. To deal with such contingencies, a bank must have sources of liquidity -
ways it can lay its hands on cash whenever it needs it. However, excess liquidity is
also costly for the bank because idle cash carries a cost as the bank pays interest on
its deposits. So, banks seek to achieve reasonable trade-off between overt liquidity
and relatively illiquidity.
Interest Rate Risk
Interest rate risk is the risk of an adverse effect of interest rate movements on a
bank's profits or balance sheet. Interest rates affect a bank in two ways - by affecting
the profits and by affecting the value of its assets or liabilities. If the money borrowed
is on floating rate basis the bank faces the risk of lower profits in an increasing
interest rate scenario. Similarly fixed rate assets face the risk of lower value of
investments in an increasing interest rate scenario. Interest rate risk becomes
prominent when the assets and liabilities of the bank do not match in their exposure
to interest rate movements.
In general, IRR has the potential to reduce a bank's earnings and lower its net worth.
IRR manifests in several different ways but a simplified example can be taken to
illustrate the general issue. The most common manifestation of IRR occurs because
the assets of the banks, such as the loans it holds, gets due or matures at a different
time than the liabilities of the bank, such as deposits.
16
Take, for example, a bank that funds itself only with certificates of deposit that have a
maturity of two years. This bank supposes grants only mortgage loans with a maturity
of 15 years. If the interest rates rise in the future, the bank would face a decline in its
expected income. Why? The monthly inflow of cash to the bank from the mortgages
is fixed for 15 years. When the certificates of deposit are due before the mortgages,
the bank will have to pay more to receive funding so cash flows out of the bank will
increase.
Clearly IRR holds the potential to have a negative impact on earnings and net worth
of a bank. So why don't banks try to eliminate it by ensuring that all of its assets and
liabilities have exactly the same maturities? Banks would earn less money without
taking on this risk. By earning the difference between long-term and short-term rates,
for example, banks are getting paid to assume IRR and meet the demands of
customers for deposits and loans. The challenge for banks is to measure IRR and
manage it such that the compensation they receive is adequate for the risks they
incur.
Regulators and banks employ a variety of different techniques to measure IRR. A
relatively simple method used by many community banks is gap analysis, which
involves grouping assets and liabilities by their maturity period, or the time period
over which the interest rate will change (the "repricing period"), such as less than
three months, three months to one year, etc. The "gap" for each category is then
expressed as the dollar value of assets minus liabilities. A large, negative gap would
indicate that the bank has a greater amount of liabilities that are repricing during that
time than assets, and therefore would be exposed to an increase in rates. A negative
gap would suggest an exposure to a decline in rates.
Regulatory agencies often employ a slightly more complex version of gap analysis to
estimate the level of IRR for a bank and for the entire banking industry. This
technique involves estimating the change in the value of assets and liabilities within
each time band at a given institution for a change in interest rate (for example, up 2
percentage points) and then calculating the aggregate difference between the two.
This amount roughly represents the loss in net worth a bank would suffer if interest
rates moved unexpectedly.
17
Consider a hypothetical bank with Rs.80 Crore in assets, Rs.60 Crore of it in
liabilities and Rs.20 Crore in equity capital. Following a 2 percentage point increase
in interest rates, the asset value of the bank drops to RS.70 Crore while the value of
liabilities falls to Rs.55 Crore. The change in net worth for this bank would be
negative Rs.5 Crore, implying that equity capital is worth only Rs.15 Crore. Typically,
the net change in economic value is expressed as a percentage of assets.
Foreign Exchange Risk
Foreign Exchange Risk is the chance that a fluctuation in the exchange rate will
change the profitability of a transaction from its expected value. It is the risk that
arises due to unanticipated changes in exchange rates, which arises due to the
presence of multi-currency assets and liabilities in a bank’s balance sheet.
Fluctuations occur over the medium and long-term and also during a dealing session
on a moment-to-moment basis.
Foreign exchange exposure in a bank might arise due to the operations of the
treasury (the dealing room) or due to unmatched assets and liabilities (in terms of
currency and maturity) on the balance sheet. In addition, banks making markets and
dealing in currency forwards, swaps and options take on foreign exchange exposure
and relevant risks. Foreign exchange operations of a bank can function properly only
if the risks associated with such operations are correctly identified and measures are
taken to manage / limit those risks.
Operational Risk:
Operations Risk encompasses the risk of loss resulting from inadequate or failed
internal processes, people and systems, or from external events. Operational risk,
which can have more far-reaching effects on a company than other risks, includes
the following:
Business risk
Legal risk
Compliance risk
Tax risk
Fraud risk
Processing and administrative risk
18
Physical asset risk
Human Resource risk
Facility risk
Mis-selling risk.
Operational risk is especially difficult to quantify because robust and objective
quantitative data is neither readily nor consistently available in many organizations.
Operations risk is the risk that deficiencies in information systems or internal controls
will result in unexpected loss. This risk is associated with human error, system
failures and inadequate procedures and controls.
Operations Risk exists for any organization arising out of day-to-day business
activities. The operations risk that a bank faces includes the risk of fraud, theft, etc.
To counter these risks, the banks have to maintain strict vigil and have to have tight
control systems. This becomes very important due to the fact that the bank is
basically investing somebody else's money. The banks typically operate by having
employee specific exposure limits to ensure that the risk taken by the bank is not too
much. There exists a risk of the mismatch in the risk taking ability of the organization
as a whole (as decided by the top management) and that of the employee who is
actually handling operations, which can lead to problems.
Credit Risk
Credit risk or default risk involves inability or unwillingness of a customer or
counterparty to meet commitments in relation to lending, trading, hedging, settlement
and other financial transactions. The credit risk of a bank’s portfolio depends on both
external and internal factors. The external factors are the state of the economy, wide
swings in commodity/equity prices, foreign exchange rates and interest rates, trade
restrictions, economic sanctions, Government policies, etc. The internal factors are
deficiencies in loan policies/administration, absence of prudential credit concentration
limits, inadequately defined lending limits for Loan Officers/Credit Committees,
deficiencies in appraisal of borrowers’ financial position, excessive dependence on
collaterals and inadequate risk pricing, absence of loan review mechanism and post
sanction surveillance, etc.
19
As per the RBI Guidance Note, October 2002
“Credit risk is defined as the possibility of losses associated with diminution in the
credit quality of borrowers or counter parties. In a bank’s portfolio, losses stem from
outright default due to inability or unwillingness of a customer or counterparty to meet
commitments in relation to lending, trading, settlement and other financial
transactions. Alternatively, losses result from reduction in portfolio value arising from
actual or perceived deterioration in credit quality. “Credit risk emanates from a bank’s
dealings with an individual, corporate, bank, financial institution or a sovereign.
Credit risk may take the following forms:
1. In the case of direct lending: principal/and or interest amount may not be
repaid;
2. In the case of guarantees or letters of credit: funds may not be forthcoming
from the constituents upon crystallization of the liability;
3. In the case of treasury operations: the payment or series of payments due
from the counter parties under the respective contracts may not be
forthcoming or ceases;
4. In the case of securities trading businesses: funds/ securities settlement may
not be effected;
5. In the case of cross-border exposure: the availability and free transfer of
foreign currency funds may either cease or restrictions may be imposed by
the sovereign.
In this backdrop, it is imperative that banks have a robust credit risk management
system, which is sensitive and responsive to these factors. The effective
management of credit risk is a critical component of comprehensive risk
management and is essential for the long-term success of any banking organization.
20
Other Risks
Country Risk
Country risk is, loosely speaking, the risk of a ‘crisis’ in a country. There are many
risks related to local crises, including:
• Sovereign risk, which is the risk of default of sovereign issuers, such as central
banks or government sponsored banks. The risk of default often refers to that of debt
restructuring for countries.
• A deterioration of the economic conditions - This might lead to a deterioration of
the credit standing of local obligors, beyond what it should be under normal
conditions. Indeed, firms’ default frequencies increase when economic conditions
deteriorate.
• A deterioration of the value of the local foreign currency in terms of the bank’s
base currency
• The impossibility of transferring funds from the country, either because there are
legal restrictions imposed locally or because the currency is not convertible any
more. Convertibility or transfer risks are common and restrictive definitions of country
risks.
• A market crisis triggering large losses for those holding exposures in the local
markets. A common practice stipulates that country risk is a floor for the risk of a
local borrower, or equivalently, that the country rating caps local borrowers’ rating. In
general, country ratings serve as benchmarks for corporate and banking entities. The
rationale is that, if transfers become impossible, the risk materializes for all
corporates in the country. There are debates around such rules, since the intrinsic
credit standing of a borrower is not necessarily lower than on that of the country.
21
Performance Risk
Performance risk exists when the transaction risk depends more on how the
borrower performs for specific projects or operations than on its overall credit
standing. Performance risk appears notably when dealing with commodities. As long
as delivery of commodities occurs, what the borrower does has little importance.
Performance risk is ‘transactional’ because it relates to a specific transaction.
Moreover, commodities shift from one owner to another during transportation. The
lender is at risk with each one of them sequentially. Risk remains more transaction-
related than related to the various owners because the commodity value backs the
transaction. Sometimes, oil is a major export, which becomes even more strategic in
the event of an economic crisis, making the financing of the commodity immune to
country risk. In fact, a country risk increase has the paradoxical effect of decreasing
the risk of the transaction because exports improve the country credit standing.
22
Types of Exposure in Forex
Exposures may be broadly classified into 3 groups:
Transaction Exposure: It is the exposure due to the trade (Current Account)
transactions. Main factor is the volatility of exchange rates. It can be covered through
forward contracts or futures or options.
The value of a firm’s cash inflows received in various currencies will be affected by
respective exchange rates of these currencies when converted into the currency
desired. Similarly, value of a firm’s cash outflows in various currencies will be
dependent on the respective exchange rates of these currencies. The degree to
which the value of future cash transactions can be affected by exchange rate
fluctuations is referred to as transaction exposure.
Illustration: An Indian Exporter exports to the US and agrees to invoice in
USD, say $1 million. At the time of receipt of order the exchange rate was Rs. 46.50
$. Then he expects Rupee value of this order at Rs. 4, 65, 00,000. If the Rupee is
likely to strengthen during the period of completion of order, say Rs. 45.30 $, then the
exporter is exposed to forex risk because of this transaction. The Rupee value of the
order would be Rs. 4, 53, 00,000, thus a potential loss of Rs. 12 lakh. If he had
agreed to invoice in Rupees then he would not have any forex exposure. However,
the US importer would have to pay more than 1 million dollars in dollar terms. Thus
now the US importer would face the exposure, instead of the Indian exporter.
Economic Exposure: It is the exposure due to setting up a factory or such long term
investment, FDI. It is an exposure in Capital Account. It cannot be covered fully.
The degree to which a firm’s present value of future cash flows can be influenced by
exchange rate fluctuations is referred to as economic exposure to exchange rates.
It thus is a comprehensive effect of potential transaction exposures on the project
investment of an MNC.
Value Added Notes
23
Illustration: If an Australian MNC would setup a manufacturing facility in
India as a subsidiary, then there will be regular transactions between the parent
company and the subsidiary. There will be a series of transaction exposures on
either account, each time they transact. As a result of such potential exposures, the
entire investment proposal, the project, itself is vulnerable to investments risk. This is
an exposure related to future cash flows, called as Economic Exposure.
Translation Exposure: It is an Accounting exposure. While MNCs consolidate their
balance sheets, this exposure is noticed. It’s a notional exposure.
The exposure of MNC’s consolidated financial statements to exchange rate
fluctuations is known as Translation exposure.
Foreign currency assets, liabilities, revenues and expenses that are
consolidated at current exchange rates into parent-currency-denominated group
financial statements. Thus in accounting terms, at the time of finalization of accounts,
value considered is at prevailing exchange rates. However, these values in accounts
would change over the period because of changes in exchange rates. These
changes would happen without any ‘trading’ or ‘speculative’ action whatsoever.
Hence it is an exposure related to ‘translation’ of one currency value to another in
accounting process.
24
Chapter 2
Risk Management in Banking
Risk Management
Risk is anything that threatens the ability of a nonprofit to accomplish its mission.
Risk management is a discipline that enables people and organizations to cope with
uncertainty by taking steps to protect its vital assets and resources. But not all risks
are created equal. Risk management is not just about identifying risks; it is about
learning to weigh various risks and making decisions about which risks deserve
immediate attention. Risk management is a process that, once understood, should
be integrated into all aspects of your organization's management.
Risk management is an essential component in the successful management of any
project, whatever its size. It is a process that must start from the inception of the
project, and continue until the project is completed and its expected benefits realized.
Risk management is a process that is used throughout a project and its products' life
cycles. It is useable by all activities in a project. Risk management must be focused
on the areas of highest risk within the project, with continual monitoring of other
areas of the project to identify any new or changing risks.
Risk Management is the process of measuring risk and then developing and
implementing strategies to manage that risk. Financial risk management focuses on
risks that can be managed ("hedged") using traded financial instruments (typically
changes in commodity prices, interest rates, foreign exchange rates and stock
prices). All large corporations have risk management teams, and small firms practice
informal, if not formal, risk management.
"If you can't afford to take a risk, then you can't afford to compete."
- former Chrysler chairman Lee Iacocca
25
Two distinct view points emerge - one which is about managing risks, maximizing
profitability and creating opportunity out of risks and the other which is about
minimizing risks/loss and protecting corporate assets. The management of an
organization needs to consciously decide on whether they want their risk
management function to 'manage' or 'mitigate' risks. Managing risks essentially is
about striking the right balance between different risks and its efficient control and
taking informed management decisions on opportunities and threats facing an
organization. Both situations, i.e. over or under controlling risks are highly
undesirable as the former means higher costs and the latter means possible
exposure to risk.
Derivatives are the instruments most commonly used in Financial Risk Management.
Because unique derivative contracts tend to be costly to create and monitor, the most
cost-effective financial risk management methods usually involve derivatives that
trade on well-established Financial Markets. These standard derivative instruments
include options, futures contracts, forward contracts, and swaps.
The most important element of managing risk is keeping losses small, which is
already part of your trading plan. Risk can be explained as uncertainty and is usually
associated with the unpredictability of an investment performance. All investments
are subject to risk, but some have a greater degree of risk than others. Risk is often
viewed as the potential for an investment to decrease in value.
Managing risk:
There are four ways of dealing with, or managing, each risk that you have identified.
You can:
Accept it
Transfer it
Reduce it
Eliminate it
26
For example, you may decide to accept a risk because the cost of eliminating it
completely is too high. You might decide to transfer the risk, which is typically done
with insurance. Or you may be able to reduce the risk by introducing new safety
measures or eliminate it completely by changing the way you produce your product.
When you have evaluated and agreed on the actions and procedures to reduce the
risk, these measures need to be put in place. Risk management is not a one-off
exercise. Continuous monitoring and reviewing is crucial for the success of risk
management process. Such monitoring ensures that risks have been correctly
identified and assessed, and appropriate controls are put in place. It is also a way to
learn from experience and make improvements to your risk management approach.
All of this can be formalized in a risk management policy, setting out your business'
approach to and appetite for risk and its approach to risk management. Risk
management will be even more effective if you clearly assign responsibility for it to
selected employees. It is also a good idea to get commitment for risk management at
the board level. Contrary to conventional wisdom, risk management is not just a
matter of running through numbers. Though quantitative analysis plays a significant
role, experience, market knowledge and judgment play a key role in proper risk
management. As complexity of financial products increase, so do the sophistication
of the risk manager's tools.
RBI guidelines
Banks in the process of financial intermediation are confronted with various kinds of
financial and non-financial risks viz., credit, interest rate, foreign exchange rate,
liquidity, equity price, commodity price, legal, regulatory, reputational, operational,
etc. These risks are highly interdependent and events that affect one area of risk can
have ramifications for a range of other risk categories. It therefore becomes very
essential for top management of banks to attach considerable importance to improve
the ability to identify measure, monitor and control the overall level of risks
undertaken. This is a new development in Indian Banking. All these decades before
the advent of Reforms the exercise of risk assessment and risk management were
never seriously considered or attempted, as the banks were operating in a captive
economy.
27
With liberalization in Indian financial markets over the last few years and growing
integration of domestic markets and with external markets, the risks associated with
banks' operations have become complex and large, requiring strategic management.
Banks are now operating in a fairly deregulated environment and are required to
determine on their own, interest rates on deposits and advance in both domestic and
foreign currencies on a dynamic basis. The interest rates on banks' investments in
government and other securities are also now market related. Intense competition for
business involving both the assets and liabilities, together with increasing volatility in
the domestic interest rates as well as foreign exchange rates, has brought pressure
on the management of banks to maintain a good balance among spreads, profitability
and long-term viability. Imprudent liquidity management can put banks' earnings and
reputation at great risk. These pressures call for structured and comprehensive
measures and not just ad hoc action. The Management of banks has to base their
business decisions on a dynamic and integrated risk management system and
process, driven by corporate strategy. Banks are exposed to several major risks in
the course of their business - credit risk, interest rate risk, foreign exchange risk,
equity / commodity price risk, liquidity risk and operational risk. It is, therefore,
important that banks introduce effective risk management systems that address the
issues related to interest rate, currency and liquidity risks.
Since the year 1998 RBI has been giving serious efforts and attention towards
evolving suitable and comprehensive models for Risk-management by the Banks and
to integrate this new discipline in the working systems of the Banks.
RBI has defined that the broad parameters of risk management function should
encompass:
1. organizational structure;
2. comprehensive risk measurement approach;
3. risk management policies approved by the Board which should be consistent
with the broader business strategies, capital strength, management expertise
and overall willingness to assume risk;
4. guidelines and other parameters used to govern risk taking including detailed
structure of prudential limits;
5. strong MIS for reporting, monitoring and controlling risks;
6. well laid out procedures, effective control and comprehensive risk reporting
framework;
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7. separate risk management framework independent of operational
Departments and with clear delineation of levels of responsibility for
management of risk; and
8. periodical review and evaluation
In terms of this objective to provide risk-management tools and strategies to the
commercial banks, RBI has been formulating a number of guidelines since 1998, to
cover each type of risk, like Asset Liability Risk, Credit Risk, Market Risk, Country
Risk etc.
NEED OF RISK MANAGEMENT IN BANKS
Assumption and management of risk is the very essence of Banking and any other
financial institution’s business. Risk here refers to the sensitivity of a Bank's or the
Institution’s profitability to spatial and temporal dispersion of market parameters (e.g.
interest rates, exchange rates, loan default, etc.) around their expected values.
Globalization, liberalization and deregulation of financial markets have resulted in
enhanced volatility in interest and exchange rates, rapid growth of innovations and a
reduction in barriers relating to business diversification. All of this has been aided by
rapid technological development. Consequently, the risks in financial markets and
availability of instruments to analyze / manage them have multiplied. A typical Bank
accepts large number of short-term deposits and tries to lend medium to long-term.
The leftover money is used for investment purposes. Thus, a bank has deposits and
equity on liability side and loans and investments on assets side of its balance sheet.
The value of each of these components is subject to uncertainties.
For Financial Institutions and Corporations, asset and liability management includes
those activities that attempt to control exposure to financial and other price risks. The
main purpose of asset and liability management is to make the consideration of risk
explicit in the planning process and to enable decision makers to control risk
exposure.
29
Any entity or investment project is bound to be exposed to price risks, and
investment planning always involves assumptions about the movements of these
prices. It aims at controlling the variability of future cash flows. Banks examine the
risk exposure of their assets and liabilities to borrowers' default rates and future asset
price movements to obtain a summary of their risk exposure profile. By entering into
a set of financial transactions, they attempt to minimize any unexpected decline in
profits. While importance of these activities has been broadly recognized in the
developed countries, applications to the banks in countries like India have been
limited.
As part of the primary activity of financial intermediation, banks borrow and lend
money. The price at which these funds are made available depends essentially on
two parameters – the time for which the funds are made available and the
creditworthiness of the person to whom the funds are made available. Considering
that the long-term funds are priced higher than short-term funds and a high-risk
borrower pays high interest rate, banks will have to take liquidity risk or credit risk to
earn the spreads. However, in the process of earning spreads, banks cannot
enhance their risks beyond a certain manageable level.
Risk manifest themselves in many ways and the risks in banking are a result of many
diverse activities, executed from many locations, and by numerous people. The
volatile nature of the bank’s operating environment will aggravate the effect of these
risks.
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Risk Control Measures
Risk management identifies future risks in order to plan control measures to prevent
its occurrence, or to control the extent of damage, if it were to occur. Obtaining
insurance cover is a generally followed risk covering method against all known and
identifiable risks, like loss in transit of goods in domestic trade, political and
commercial risks in export business, fire-risks etc. Financial risks are covered by a
process known as hedging. Hedging helps to reduce risks associated with market
exposure by taking a counter position in the futures market, i.e. buy stock, sell Nifty
futures etc. The development of derivatives market is a device for hedging different
kinds of financial risks.
Another innovative tool for hedging financial risks is called "Interest-rate-swaps". This
is explained as under.
The Corporations in which individual investors place their money have exposure to
fluctuations in all kinds of financial prices, as a natural consequence of their
operations. Financial prices include foreign exchange rates, interest rates,
commodity prices and injustice prices. The changes in the financial prices cause
uncertainty in the projected revenues to the corporate sector. And the companies
often attribute the cause in decline in incomes to falling commodity prices, raising
interest rates, declining home currency value. Necessity is the mother of invention.
Human quest to find the solution continues. In this process various financial
instruments were invented. Interest rate swap is one of the risk tools that helps the
corporate to hedge from uncertainties of the interest rate fluctuations.
The Reserve Bank of India has taken a bold step towards rupee derivative trading
allowing banks/financial institutions to hedge against interest rate risks through the
use of interest rate swaps and forward rate agreements.
Similarly the risk of exchange-rate fluctuations can be covered by entering into
forward contract for buying/selling the foreign currency.
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Value Added Notes
FEDAI Guidelines for Foreign Exchange
Established in 1958, FEDAI (Foreign Exchange Dealers' Association of India)
is a group of banks that deals in foreign exchange in India as a self regulatory body
under the Section 25 of the Indian Company Act (1956).
The role and responsibilities of FEDAI are as follows:
1. Formulations of FEDAI guidelines and FEDAI rules for Forex business.
2. Training of bank personnel in the areas of Foreign Exchange Business.
3. Accreditation of Forex Brokers.
4. Advising/Assisting member banks in settling issues/matters in their dealings.
5. Represent member banks on Government/Reserve Bank of India and other
bodies.
6. Rules of FEDAI also include announcement of daily and periodical rates to its
member banks.
FEDAI guidelines play an important role in the functioning of the markets and
work in close coordination with Reserve Bank of India (RBI), other organizations like
Fixed Income Money Market and Derivatives Association (FIMMDA), the Forex
Association of India and various other market participants.
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Chapter 3
International Trade Finance
Let’s first understand International trade.
International Trade is the exchange of capital, goods and services across
international boundaries or territories. In most countries, it represents a significant
share of GDP. While international trade has been present throughout much of
history, it’s economic, social, and political importance has been on the rise in recent
centuries. Industrialization, advanced transportation, globalization, multinational
corporations, and outsourcing are all having a major impact on the international trade
system. Increasing international trade is crucial to the continuance of globalization.
International trade is a major source of economic revenue for any nation that is
considered a world power. Without international trade, nations would be limited to the
goods and services produced within their own borders.
International trade is in principle not different from domestic trade as the motivation
and the behavior of parties involved in a trade does not change fundamentally
depending on whether trade is across a border or not. The main difference is that
international trade is typically more costly than domestic trade. The reason is that a
border typically imposes additional costs such as tariffs, time costs due to border
delays and costs associated with country differences such as language, the legal
system or a different culture.
Another difference between domestic and international trade is that factors of
production such as capital and labor are typically more mobile within a country than
across countries. Thus international trade is mostly restricted to trade in goods and
services, and only to a lesser extent to trade in capital, labor or other factors of
production. Then trade in good and services can serve as a substitute for trade in
factors of production. Instead of importing the factor of production a country can
import goods that make intensive use of the factor of production and are thus
embodying the respective factor. An example is the import of labor-intensive goods
...the only means to well-being is to increase the quantity of products. This is what business aims at.
- Ludvig von mises
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by the United States from China. Instead of importing Chinese labor the United
States is importing goods from China that were produced with Chinese labor.
International trade is also a branch of economics, which, together with international
finance, forms the larger branch of international economics.
Current Scenario of India’s International Trade
Let’s now understand the exchange rate scenario of INR/USD and its relationship
with and impact on India’s international trade
As you can observe below from the chart, INR was appreciating against USD and
reached a record level of 39.27 on 07/11/2007. It is because at that time US was
feeling the pinch of sub prime crisis and was facing recession while India on the other
hand was having a growing GDP, booming markets and inflation below the tolerance
level of 5%.
But when INR appreciated at such levels exporters were adversely affected and
importers were enjoying such appreciation of INR because importers were now able
to get USD at a much lower rate which meant cheap imports but at the cost of
domestic manufacturers. On the other hand exporters who had booked the contracts
in terms of USD (when USD/INR was at Rs. 44-45 levels) they got the contract
amount in USD but got lesser INR because of such appreciation and exporters who
had huge forex exposure were badly affected.
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RBI was also feeling the pinch as it was holding huge forex reserves. So to control
the situation it was:
Indulging in purchasing more and more forex reserves, so that the demand
for USD increases and it starts appreciating again;
Extending the DEPB scheme so that exporters’ capital is not locked up;
Reducing interest rate for exporters up to 2%;
Open Market operations.
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But now the situation is totally reversed. Inflation is at record highs. It has crossed the
double digit figure and stands at 11.63% for the week ended 21st June, 2008.
It can be observed that when INR was appreciating (against USD); inflation was
under the tolerance level of 5%. But when the INR started depreciating inflation rate
increased drastically.
Another reason for increasing inflation is the surging oil prices posing a threat to
break the psychological barrier of $150/barrel (currently above $140/barrel).
36
Due to which oil marketing companies like Indian Oil Corporation Ltd., Bharat
Petroleum and Hindustan Petroleum are feeling the heat and are facing trouble. For
this purpose, petrol price were increased by Rs. 4, diesel by Rs. 2 and LPG cylinder
by Rs. 50. It has also been announced to issue more oil bonds for oil marketing
companies.
RBI has also increased the repo rate to 9% and CRR to 9% in addition to the steps
mentioned earlier.
RBI states that it will be able to bring inflation down to 7% by the end of March, 2009.
Despite, it is predicted that inflation will remain in 2 digits at the end of of March,
2009.
37
India’s BoP position
Now having understood the impact of exchange rates on international trade and the
economy at large let’s look at the BoP (Balance of Payment) position of India.
Major Items of India's Balance of Payments
(US $ million)
Item 2007-08P 2006-07PR 2005-06R
1. Exports 158,461 128,083 105,152
2. Imports 248,521 191,254 157,056
3. Trade Balance (1-2) -90,060 -63,171 -51,904
4. Invisibles, net 72,657 53,405 42,002
5. Current Account Balance (3+4) -17,403 -9,766 -9,902
6. Capital Account* 109,567 46,372 24,954
7. Change in Reserves#
(- Indicates increase)
-92,164 -36,606 -15,052
*: Including errors and omissions.
#: On BoP basis excluding valuation.
P: Preliminary.
PR: Partially Revised.
R: Revised
There is a sharp rise in trade deficit (7.7% of GDP in 2007-08 from 6.9% in 2006-07).
Also there has been a significant increase in invisible surplus led by remittances from
overseas Indians and software services.
As you can observe current account deficit has almost doubled showing the signs of
increasing imports at a much higher rate than that of exports. (yoy)
38
39
Union Bank of India & its Overseas Department
UNION BANK OF INDIA was inaugurated by none other than the Father of the
Nation, Mahatma Gandhi. Since that the golden moment, Union Bank of India has
this far unflinchingly traveled the arduous road to successful banking …. a journey
that spans 88 years.
Union Bank of India is firmly committed to consolidating and maintaining its identity
as a leading, innovative commercial Bank, with a proactive approach to the changing
needs of the society. This has resulted in a wide gamut of products and services,
made available to its valuable clientele in catering to the smallest of their needs.
Today, with its efficient, value-added services, sustained growth, consistent
profitability and development of new technologies, Union Bank has ensured complete
customer delight, living up to its image of, “GOOD PEOPLE TO BANK WITH”.
Anticipative banking- the ability to gauge the customer's needs well ahead of real-
time - forms the vital ingredient in value-based services to effectively reduce the gap
between expectations and deliverables.
The key to the success of any organization lies with its people. Union Bank's family
comprises of about 26,000 qualified / skilled employees.
Union Bank is a Public Sector Unit with 55.43% Share Capital held by the
Government of India. The Bank came out with its Initial Public Offer (IPO) in August
20, 2002 and Follow on Public Offer in February 2006. Presently 44.57 % of Share
Capital is presently held by Institutions, Individuals and Others.
Over the years, the Bank has earned the reputation of being a techno-savvy and is a
front runner among public sector banks in modern-day banking trends. It is one of the
pioneer public sector banks, which launched Core Banking Solution in 2002. And
now it has succeeded in becoming a 100% CBS networking Bank. Under this
solution umbrella, All Branches of the Bank have been 1135 networked ATMs, with
online Telebanking facility made available to all its Core Banking Customers -
individual as well as corporate. In addition to this, the versatile Internet Banking
provides extensive information pertaining to accounts and facets of banking. Regular
banking services apart, the customer can also avail of a variety of other value-added
services like Cash Management Service, Insurance, Mutual Funds and Demat.
40
The Bank will ever strive in its endeavor to provide services to its customer and
enhance its businesses thereby fulfilling its vision of becoming “THE BANK OF
FIRST CHOICE IN OUR CHOSEN AREA BY BUILDING BENEFICIAL AND
LASTING RELATIONSHIP WITH CUSTOMERS THROUGH A PROCESS OF
CONTINUOUS IMPROVEMENT”.
The overseas department of UBI consists of the following departments:
1. Exports
2. Imports
3. Guarantees
4. Remittances
5. Advances
There are more than 90 clients in the overseas department of UBI. It consist both
domestic trade finance and international trade finance. There are around 20
employees working in the different departments mentioned above. The entire branch
mainly is in performing day to day operational work. Its client base includes many
jewellery/diamond export/import firms.
Later we will learn more about the above fields and how they handle the risks
involved in it. In short we will learn about the risk management techniques used in
these different departments.
41
Inco terms 2000 - International Commercial Terms used in Export Import
Objectives
Incoterms are internationally accepted commercial terms, developed in 1936 by the
International Chamber of Commerce (ICC) in Paris. Incoterms 2000 define the
respective roles of the buyer and seller in the agreement of transportation and other
responsibilities and clarify when the ownership of the merchandise takes place.
These terms are incorporated into export-import sales agreements and contracts
worldwide and are a necessary part of foreign trade.
Incoterms are used in union with a sales agreement or other methods of sales
transactions and define the responsibilities and obligations of both, the exporter and
importer in Foreign Trade Transactions.
The main objectives of Incoterms 2000 revolve around the contract of Foreign Trade
concerned with the loading, transport, insurance and delivery transactions. Its main
function is the distribution of goods and regulation of transport charges.
Another significant role played by Incoterms is to identify and define the place of
transfer and the transport risks involved in order to justify the ownership for support
and damage of goods by shipments sent by the seller or the buyer in an event of
execution of transport.
Incoterms make international trade easier and help traders in different countries to
understand one another. These International Commercial Terms are the most widely
used international contracts protected by the ICC copyright.
Incoterms safeguard the following issues in the Foreign Trade contract or
International Trade Contract:
1. To determine the critical point of the transfer of the risks of the seller to the
buyer in the process forwarding of the goods (risks of loss, deterioration,
robbery of the goods) allow the person who supports these risks to make
arrangements in particular in term of insurance.
2. To specify who is going to subscribe the contract of carriage that is to say the
seller (exporter) or the buyer (importer).
42
3. To distribute between the seller and the buyer the logistic and administrative
expenses at the various stages of the process.
4. It is important to define who is responsible for packaging, marking, operations
of handling, loading and unloading, inspection of the goods.
5. Need To confirm and fix respective obligations for the achievement of the
formalities of exportation and importation, the payment of the rights and taxes
of importation as well as the sending of the documents. In dealing Foreign
Trade there are 13 Incoterms globally adopted by the International Chamber
of Commerce.
INTERNATIONAL INCOTERMS
Incoterms or International commercial terms make trade between different countries
easier. International Commercial Terms are a series of international trade terms that
are used are used worldwide to divide he transaction costs and responsibilities
between the seller and the buyer and reflect state-of-the-art transportation practices.
Incoterms directly deal with the questions related to the delivery of the products from
the seller to the buyer. This includes the carriage of products, export and import
responsibilities, who pays for what and who has the risk for the condition of the
products at different locations within the transport process.
Incoterms and world customs Incoterms deal with the various trade transactions all
over the world and clearly distinguish between the respective responsibilities of the
seller and the buyers.
43
The 13 International Incoterms are:
EXW FCA FAS FOB CFR CIF CPT CIP DAF DES DEQ DDU DDP
SERVICE
S
Ex
Work
s
Free
Carri
er
Free
Along
side
Ship
Free
Onbo
ard
Vessel
Cost
&
Freig
ht
Cost
Insura
nce &
Freight
Carri
age
Paid
To
Carria
ge
Insura
nce
Paid To
Deliver
ed At
Frontie
r
Deliver
ed Ex
Ship
Deliver
ed Ex
Quay
Duty
Unpaid
Deliver
ed Duty
Unpaid
Deliver
ed Duty
Paid
Warehouse
StorageSeller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller
Warehouse
LaborSeller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller
Export
PackingSeller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller
Loading
ChargesBuyer Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller
Inland
FreightBuyer
Buyer/
Seller
*
Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller
Terminal
ChargesBuyer Buyer Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller
Forwarder's
FeesBuyer Buyer Buyer Buyer Seller Seller Seller Seller Seller Seller Seller Seller Seller
Loading On
VesselBuyer Buyer Buyer Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller
Ocean/Air
FreightBuyer Buyer Buyer Buyer Seller Seller Seller Seller Seller Seller Seller Seller Seller
Charges On
Arrival At
Destination
Buyer Buyer Buyer Buyer Buyer Buyer Seller Seller Buyer Buyer Seller Seller Seller
Duty, Taxes
& Customs
Clearance
Buyer Buyer Buyer Buyer Buyer Buyer Buyer Buyer Buyer Buyer Buyer Buyer Seller
Delivery To
DestinationBuyer Buyer Buyer Buyer Buyer Buyer Buyer Buyer Buyer Buyer Buyer Seller Seller
Source: www.i-b-t.net
* There are actually two FCA terms: FCA Seller's Premises where the seller is
responsible only for loading the goods and not responsible for inland freight; and
FCA Named Place (International Carrier) where the seller is responsible for inland
freight.
44
Having gone through the International trade scenario of India and the international
commercial terms used in international trade let’s understand the important risk
management documents involved in international trade finance.
Introduction to International Trade Documents
International market involves various types of trade documents that need to be
produced while making transactions. Each trade document is differ from other and
present the various aspects of the trade like description, quality, number,
transportation medium, indemnity, inspection and so on. So, it becomes important for
the importers and exporters to make sure that their documents support the guidelines
as per international trade transactions. A small mistake could prove costly for any of
the parties.
For example, a trade document about the bill of lading is a proof that goods have
been shipped on board, while Inspection Certificate certifies that the goods have
been inspected and meet quality standards. So, depending on these necessary
documents, a seller can assure a buyer that he has fulfilled his responsibility whilst
the buyer is assured of his request being carried out by the seller.
The following is a list of documents often used in international trade:
Air Waybill
Bill of Lading
Certificate of Origin
Combined Transport Document
Draft (or Bill of Exchange)
Insurance Policy (or Certificate)
Packing List/Specification
Inspection Certificate
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Air Waybills
Air Waybills make sure that goods have been received for shipment by air. A typical
air waybill sample consists of three originals and nine copies. The first original is for
the carrier and is signed by a export agent; the second original, the consignee's
copy, is signed by an export agent; the third original is signed by the carrier and is
handed to the export agent as a receipt for the goods.
Air Waybills serves as:
Proof of receipt of the goods for shipment.
An invoice for the freight.
A certificate of insurance.
A guide to airline staff for the handling, dispatch and delivery of the
consignment.
The principal requirements for an air waybill are:
The proper shipper and consignee must be mention.
The airport of departure and destination must be mention.
The goods description must be consistent with that shown on other
documents.
Any weight, measure or shipping marks must agree with those shown on
other documents.
It must be signed and dated by the actual carrier or by the named agent of a
named carrier.
It must mention whether freight has been paid or will be paid at the
destination point.
Bill of Lading (B/L)
Bill of Lading is a document given by the shipping agency for the goods shipped
for transportation form one destination to another and is signed by the
representatives of the carrying vessel.
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Bill of lading is issued in the set of two, three or more. The number in the set will be
indicated on each bill of lading and all must be accounted for. This is done due to the
safety reasons which ensure that the document never comes into the hands of an
unauthorized person. Only one original is sufficient to take possession of goods at
port of discharge so, a bank which finances a trade transaction will need to control
the complete set. The bill of lading must be signed by the shipping company or its
agent, and must show how many signed originals were issued.
It will indicate whether cost of freight/ carriage has been paid or not:
"Freight Prepaid”: Paid by shipper
"Freight collect”: To be paid by the buyer at the port of discharge
The bill of lading also forms the contract of carriage.
To be acceptable to the buyer, the B/L should:
Carry an "On Board" notation to showing the actual date of shipment,
(Sometimes however, the "on board" wording is in small print at the bottom of
the B/L, in which cases there is no need for a dated "on board" notation to be
shown separately with date and signature.)
Be "clean" having no notation by the shipping company to the effect that
goods/ packaging are damaged.
The main parties involve in a bill of lading are:
Shipper
o The person who send the goods.
Consignee
o The person who take delivery of the goods.
Notify Party
o The person, usually the importer, to whom the shipping company or its
agent gives notice of arrival of the goods.
Carrier
o The person or company who has concluded a contract with the
shipper for conveyance of goods
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The bill of lading must meet all the requirements of the credit as well as complying
with UCP 600. These are as follows:
The correct shipper, consignee and notifying party must be shown.
The carrying vessel and ports of the loading and discharge must be stated.
The place of receipt and place of delivery must be stated, if different from port
of loading or port of discharge.
The goods description must be consistent with that shown on other
documents.
Any weight or measures must agree with those shown on other documents.
Shipping marks and numbers and /or container number must agree with
those shown on other documents.
It must state whether freight has been paid or is payable at destination.
It must be dated on or before the latest date for shipment specified in the
credit.
It must state the actual name of the carrier or be signed as agent for a named
carrier.
Certificate of Origin
The Certificate of Origin is required by the custom authority of the importing country
for the purpose of imposing import duty. It is usually issued by the Chamber of
Commerce and contains information like seal of the chamber, details of the good to
be transported and so on.
The certificate must provide that the information required by the credit and be
consistent with all other document, It would normally include:
The name of the company and address as exporter.
The name of the importer.
Package numbers, shipping marks and description of goods to agree with that
on other documents.
Any weight or measurements must agree with those shown on other
documents.
It should be signed and stamped by the Chamber of Commerce.
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Combined Transport Document
Combined Transport Document is also known as Multimodal Transport Document,
and is used when goods are transported using more than one mode of
transportation. In the case of multimodal transport document, the contract of carriage
is meant for a combined transport from the place of shipping to the place of delivery.
It also evidence receipt of goods but it does not evidence on board shipment, if it
complies with ICC 500, Art. 26 (a). The liability of the combined transport operator
starts from the place of shipment and ends at the place of delivery. This documents
need to be signed with appropriate number of originals in the full set and proper
evidence which indicates that transport charges have been paid or will be paid at
destination port.
Multimodal transport document would normally show:
That the consignee and notify parties are as the credit.
The place goods are received, or taken in charges, and place of final
destination.
Whether freight is prepaid or to be collected.
The date of dispatch or taking in charge, and the "On Board" notation, if any
must be dated and signed.
Total number of originals.
Signature of the carrier, multimodal transport operator or their agents.
Commercial Invoice
Commercial Invoice document is provided by the seller to the buyer. Also known as
export invoice or import invoice, commercial invoice is finally used by the custom
authorities of the importer's country to evaluate the good for the purpose of taxation.
The invoice must:
Be issued by the beneficiary named in the credit (the seller).
Be address to the applicant of the credit (the buyer).
Be signed by the beneficiary (if required).
Include the description of the goods exactly as detailed in the credit.
Be issued in the stated number of originals (which must be marked "Original)
and copies.
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Include the price and unit prices if appropriate.
State the price amount payable which must not exceed that stated in the
credit
Include the shipping terms.
Bill of exchange
A Bill of Exchange is a special type of written document under which an exporter ask
importer a certain amount of money in future and the importer also agrees to pay the
importer that amount of money on or before the future date. This document has
special importance in wholesale trade where large amount of money involved.
Following persons are involved in a bill of exchange:
Drawer: The person who writes or prepares the bill.
Drawee: The person who pays the bill.
Payee: The person to whom the payment is to be made.
Holder of the Bill: The person who is in possession of the bill.
On the basis of the due date there are two types of bill of exchange:
Bill of exchange after Date: In this case the due date is counted from the
date of drawing and is also called bill after date.
Bill of exchange after Sight: In this case the due date is counted from the
date of acceptance of the bill and is also called bill of exchange after sight.
Insurance Certificate
Also known as Insurance Policy, it certifies that goods transported have been insured
under an open policy and is not actionable with little details about the risk covered.
It is necessary that the date on which the insurance becomes effective is same or
earlier than the date of issuance of the transport documents.
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Also, if submitted under a LC, the insured amount must be in the same currency as
the credit and usually for the bill amount plus 10 per cent.
The requirements for completion of an insurance policy are as follow:
The name of the party in the favor which the documents have been issued.
The name of the vessel or flight details.
The place from where insurance is to commerce typically the sellers
warehouse or the port of loading and the place where insurance cases
usually the buyer's warehouse or the port of destination.
Insurance value that specified in the credit.
Marks and numbers to agree with those on other documents.
The description of the goods, which must be consistent with that in the credit
and on the invoice.
The name and address of the claims settling agent together with the place
where claims are payable.
Countersigned where necessary.
Date of issue to be no later than the date of transport documents unless cover
is shown to be effective prior to that date.
Packing List
Also known as packing specification, it contains details about the packing materials
used in the shipping of goods. It also includes details like measurement and weight
of goods.
The packing List must:
Have a description of the goods ("A") consistent with the other documents.
Have details of shipping marks ("B") and numbers consistent with other
documents
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Inspection Certificate
Certificate of Inspection is a document prepared on the request of seller when he
wants the consignment to be checked by a third party at the port of shipment before
the goods are sealed for final transportation.
In this process seller submit a valid Inspection Certificate along with the other trade
documents like invoice, packing list, shipping bill, bill of lading etc to the bank for
negotiation.
On demand, inspection can be done by various world renowned inspection agencies
on nominal charges.
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LERMS
LERMS (Liberalized Exchange Rate Management System) was introduced in March
1992. It is a dual exchange rate system in the place of a single official rate. It
consisted of one official rate for select government and private transactions and the
market determined rate for the others.
It treated current and capital transactions in the different ways. There were
requirements of surrender of foreign exchange by the public to banks with some
exceptions.
Under the LERMS exports of goods and services who are in receipt of bulk of foreign
exchange will have to sell their foreign exchange at the market rate in the foreign
exchange market except 40% of their foreign exchange earnings which will have to
be surrendered to the monetary authority of India i.e. RBI at an official rate. (i.e. the
balance 60% of their foreign exchange earnings will have to be sold in the free
market at the marked rate.)
The RBI will sell foreign exchange at the official rate to authorized dealers only for:
1. Imports of specified goods covering governmental needs,
2. Imports under EXIM scraps unutilized as on February 29, 1992, and
3. Imports of life saving drugs and equipments under licenses.
For Import under advance licenses and special impress licenses and imports for
replenishment of raw materials for gem and jewelers exports foreign exchange will be
available at official rate for 40% of the value. The remaining requirements will be met
through purchases in the free market.
Value Added Notes
53
Chapter 4
Risk Management in Import Advances
International Trade involves various complexities and problems. This may be due to
various reasons. The parties to a sale contract are located in different countries and
are governed by different legal systems. Also, the currencies of the two countries are
different. Further, the trade and exchange regulations applicable to both the parties
may differ. In such a situation, a seller who ships goods will be apprehensive whether
he will receive payment from the buyer. The buyer, on the other hand, will be
concerned whether the seller will ship the goods ordered for and deliver them in time.
Given these complexities, a need for an ideal method of settling international trade
payments was felt and so came the usage of documentary credits, commonly known
as LC into vogue.
Even this arrangement, initially created discomfiture as parties involved in the
transaction have been using different terminologies, interpreting the arrangement in
different ways. Subsequently, ICC came up with a set of guidelines in the name of
Uniform Customs and Practice for Documentary Credits (UCPDC) to facilitate
uniform interpretation of terminology used under documentary credit by all the
concerned. The UCPDC first appeared in 1933 and since then is getting refined with
the experiences gained from time to time. The latest revision under this, took place
during 1993 and the document issued under publication no. 500 is currently in force.
The UCPDC has thus attained universal acceptance and the local courts too are
referring to these articles while settling trade disputes.
"The policy of being too cautious is the greatest risk of all." - Jawaharlal Nehru
54
Introduction to L/C
Letter of Credit L/C also known as Documentary Credit is a widely used term to
make payment secure in domestic and international trade. The document is issued
by a financial organization at the buyer request. Buyer also provides the necessary
instructions in preparing the document.
The International Chamber of Commerce (ICC) in the Uniform Custom and Practice
for Documentary Credit (UCPDC) defines L/C as:
"An arrangement, however named or described, whereby bank (the Issuing bank)
acting at the request and on the instructions of a customer (the Applicant) or on its
own behalf:
1. Is to make a payment to or to the order third party (the beneficiary) or is to
accept bills of exchange (drafts) drawn by the beneficiary.
2. Authorized another bank to effect such payments or to accept and pay such
bills of exchange (draft).
3. Authorized another bank to negotiate against stipulated documents provided
that the terms are complied with.
A key principle underlying letter of credit (L/C) is that banks deal only in documents
and not in goods.
How the L/C operates?
55
Parties to Letters of Credit
Applicant (Opener): Applicant which is also referred to as account party is
normally a buyer or customer of the goods, who has to make payment to
beneficiary. LC is initiated and issued at his request and on the basis of his
instructions.
Issuing Bank (Opening Bank): The issuing bank is the one which create a
letter of credit and takes the responsibility to make the payments on receipt of
the documents from the beneficiary or through their banker.
Beneficiary: Beneficiary is normally stands for a seller of the goods, who has
to receive payment from the applicant.
Advising Bank: An Advising Bank provides advice to the beneficiary and
takes the responsibility for sending the documents to the issuing bank and is
normally located in the country of the beneficiary.
Confirming Bank: Confirming bank adds its guarantee to the credit opened
by another bank, thereby undertaking the responsibility of
payment/negotiation acceptance under the credit, in additional to that of the
issuing bank. Confirming bank play an important role where the exporter is
not satisfied with the undertaking of only the issuing bank.
Negotiating Bank: The Negotiating Bank is the bank who negotiates the
documents submitted to them by the beneficiary under the credit either
advised through them or restricted to them for negotiation. On negotiation of
the documents they will claim the reimbursement under the credit and makes
the payment to the beneficiary provided the documents submitted are in
accordance with the terms and conditions of the letters of credit.
Reimbursing Bank: Reimbursing Bank is the bank authorized to honor the
reimbursement claim in settlement of negotiation/acceptance/payment lodged
with it by the negotiating bank. It is normally the bank with which issuing bank
has an account from which payment has to be made.
Second Beneficiary: Second Beneficiary is the person who represents the
first or original Beneficiary of credit in his absence.
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Types of Letter of Credit
1. Revocable Letter of Credit L/C
A revocable letter of credit may be revoked or modified for any reason, at any time by
the issuing bank without notification.
2. Irrevocable Letter of Credit L/C
In this case it is not possible to revoke or amended a credit without the agreement of
the issuing bank, the confirming bank, and the beneficiary.
3. Confirmed Letter of Credit L/C
Confirmed Letter of Credit is a special type of L/C in which another bank apart from
the issuing bank has added its guarantee.
4. Sight Credit and Usance Credit L/C
Sight credit states that the payments would be made by the issuing bank at sight, on
demand or on presentation. In case of usance credit, draft is drawn on the issuing
bank or the correspondent bank at specified usance period.
5. Back to Back Letter of Credit L/C
Back to Back Letter of Credit is also termed as Countervailing Credit. A credit is
known as back-to-back credit when a L/C is opened with security of another L/C.
6. Transferable Letter of Credit L/C
It is a type of credit under which the first beneficiary which is usually a middleman
may request the nominated bank to transfer credit to the second beneficiary.
7. Standby Letter of Credit L/C
Initially used by the banks in the U.S, the standby letter of credit is very much similar
in nature to a bank guarantee. The main objective of issuing such a credit is to
secure bank loans. It is usually issued by the applicant’s bank in the applicant’s
country and advised to the beneficiary by a bank in the beneficiary’s country.
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Risk Associated with Opening Imports L/C’s
The basic risk associated with an issuing bank while opening an import L/C is:
1. The financial standing of the importer:
As the bank is responsible to pay the money on the behalf of the importer,
thereby the bank should make sure that it has the proper funds to pay.
2. The goods
Bankers need to do a detail analysis against the risks associated with
perishability of the goods, possible obsolescence, import regulations packing
and storage, etc. Price risk is another crucial factor associated with all modes
of international trade.
3. Exporter Risk
There is always the risk of exporting inferior quality goods. Banks need to be
protective by finding out as much possible about the exporter using status
report and other confidential information.
4. Country Risk
These types of risks are mainly associated with the political and economic
scenario of a country. To solve this issue, most banks have specialized unit
which control the level of exposure that that the bank will assumes for each
country.
5. Foreign exchange risk
Foreign exchange risk is another most sensitive risk associated with the
banks. As the transaction is done in foreign currency, the traders depend a lot
on exchange rate fluctuations.
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Risk Management tools used
Scrutiny of documents
This is a very important function and this should be done with great care. After
receiving the document from the overseas supplier's bank the importer's bank will
scrutinize them to verify the extent of correctness as per the terms of the L/C. For
discrepancies in the documents following principles are adopted:
If discrepancies are such which violates any of exchange control or import
control regulations, the documents should straightaway be rejected.
If the discrepancies are of trivial nature not affecting the character of the
transactions the documents may be accepted on merits.
If the documents are rejected, immediate notice to that effect should be given
to the bank to safeguard the importer's interests. The documents prescribed
by the beneficiary are carefully scrutinized by the issuing banker. The
importer should also scrutinize the documents to ensure that:
1. They were presented when the credit was in force and had not
expired.
2. The amendments and special instructions have been taken care
of.
3. The amount of bill does not exceed the value of L/C.
4. All documents required in the L/C have been made available.
5. Documents carry required endorsements.
6. The documents do not contain discrepancies which violate any
exchange control/import control regulations.
7. The invoice is duly signed; tallies with amount of draft, exact
quantities are shown and are drawn in appropriate currency of the
origin of goods.
8. Bill of lading is presented in full set of negotiable copies and is on
board bill of lading and duly signed.
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In case the goods are imported on cash against documents (CAD), documents
against payment (D/P) or documents against acceptance (D/A) basis, the importer
needs to take delivery of documents from the banker before completion of the
customs formalities. This process, known as retirement of documents, needs the
importer to apply to authorized dealer/banker who is in possession of documents.
This can be done by tendering the funds equivalent to the value of documents and
the bank charges exchange control copy of import license, where applicable, Form A-
1 duly completed for remittance of foreign exchange.
The documents are released to the importers against payment in case of DP bills and
against acceptance in case of DA bills. The payment in either case is accepted only
from the bank account of importer. If the bank is out of funds the interest is charged
to the importer's account. For any overdue period a penal interest will be charged.
Checklist for Document (received under L/C) scrutiny:
1. General-check whether all documents in full sets as per L/C terms have been
received.
2. Documents had been presented before the expiry date.
3. All the documents are dated subsequent to the date of issue of the L/C.
4. Cancellation/overwriting in all documents are authenticated.
5. Bills of Exchange-check whether:
Drawn on the person indicated in the L/C and duly signed up by the
beneficiary of the credit.
Drawing is within L/C amount and in the same currency as per the
L/C. The amounts in words and figures are the same and identical
with the amount stated in the invoice.
6. Superscription, regarding drawing under L/C has been made and the Bill must
have been issued stamped.
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7. Invoice- check, whether invoice:
Is made out in the name of the person who had opened the L/C.
Quantity, unit price and value are quoted as per L/C.
Whether unit price and value are quoted as per L/C.
The description of the merchandise corresponds to the description in the
L/C.
The arithmetical calculations are correct.
Import license/OGL/Contract No./Order No./Indent No. mentioned as per
L/C.
No charge other than stipulated in L/C in included.
Additional copy for Exchange Control purposes is submitted.
The date and no. of the License/OGL indicated.
8. Bill of lading is submitted within 21days from the date of shipment, if no
specific time is between the date of issue and expiry of L/C.
9. The date of shipment is between the date of issue and expiry of L/C.
10. Full quantity of goods is shipped, if part shipment is not allowed.
11. Full set is submitted.
12. Freight is shown as prepaid/payable at destination, as per L/C.
13. Bill of lading shows 'on board shipment'.
14. Parties are notified as per L/C terms.
15. Carrying vessel's name has been mentioned in Bill of Lading.
16. The beneficiary's name is shown as consignor, unless L/C terms permits
third party bill of lading.
17. The consignee's name is as per L/C.
18. The B/L is manually signed.
19. The description of goods is consistent with L/C.
20. The ports of loading/destination are mentioned as per L/C.
21. Marks, numbers, quantity and weight agree with the invoice.
22. The carrying vessel belongs to any particular line as per L/C.
23. Adequately stamped.
24. Properly endorsed.
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Scrutiny for Insurance documents-check whether the policy is taken out in the
name of the shipper
Certificate/policy is according to Letter of Credit terms
Risk commences w.e.f. date of B/L
Amount of insurance as per L/C terms
Whether drawn in the same currency as the L/C
Description of goods agree with B/L
Risks as per L/C are covered
The place where claims are payable is as per L/C terms
Adequately stamped
Details such as name of carrying vessel, ports of loading/destination, marks, agree
with the B/L
Certificate of analysis, weighment,etc.
The certificates are issued by the authority stipulated in L/C
Name of the shipper is properly shown
The samples drawn relate to the goods actually shipped
Date of sample verification is within the date of shipment
Certificate of origin
It is issued by the authority stipulated in the L/C and the description of goods agrees
with that in the invoice
Checking other documents
All other documents stipulated in the L/C are verified
They are issued by the authorities specified in the L/C
They contain the details as required by the L/C
For matter relating to Documentary Collections and Commercial terms, the importers
are likely to be conversant with the brochures issued by the International Chamber of
Commerce (ICC), Paris.
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Forward Contracts
Forward Contract can be defined as a contract deliverable on a future date, duration
of the contract being computed from spot value date at the time of transaction.
Forward contract is an agreement to exchange one currency for another currency on
a specific date in future at a predetermined exchange rate, set at the time the
contract is made.
A forward contract is traded in the over-the-counter market—usually between two
financial institutions or between a financial institution and one of its clients.
One of the parties to a forward contract assumes a long position and agrees to buy
the underlying asset on a certain specified future date for a certain specified price.
The other party assumes a short position and agrees to sell the asset on the same
date for the same price.
Forward contracts on foreign exchange are very popular. Most large banks have a
"forward desk" within their foreign exchange trading room that is devoted to the
trading of forward.
Forward contracts are used to hedge foreign currency risk.
One of the factors influencing a currency’s forward exchange rate is the level of
interest rates for that currency relative to interest rates in the other currency. There
are many theories on how a forward exchange rate can be calculated, but market
participants adopt the interest rate differential between two currencies and the
current market spot rate as the basis of their calculations. The forward price is often
referred to as forward points, forward pips or swap points (pips).
For example, assume that the spot and forward rates between dollars and sterling
are the same, but the interest rates in sterling are 4% per annum for a 3-month
deposit, while in dollars they are 2%. Investors would sell their dollars and buy
sterling spot for the higher yield. They would simultaneously sell sterling and buy
dollars forward for delivery at the end of the investment period. In this way, the
investor would end up with more dollars than if the investment had been kept in
dollars.
63
Forward contract prices are determined by two main factors: the current spot price
between the two currencies and the interest rate prevailing in each of the two
currencies. The forward price is calculated as follows:
Forward Rate = Spot Rate + Premium / - Discount
To decide whether to add or subtract the forward pips, firstly determine whether the
currency to be bought or sold is trading at a premium or is trading at a discount. As
all exchange rates have a fixed and a variable component, if the interest rates in the
variable currency are greater than those of the fixed currency, the variable currency
is trading at a discount relative to the fixed currency and forward pips are added to
the spot rate to obtain the forward rate. If the interest rates in the variable currency
are less than those of the fixed currency, the variable currency is trading at a
premium and forward pips are subtracted from the spot rate to obtain the forward
rate.
In calculating the forward points, users adopt a simple arithmetic formula which takes
the interest rate differential per annum, converts it into a differential for the required
period, and expresses the spot rate as a percentage of the differential for the period.
However, it cannot be used entirely in isolation, for it assumes knowledge of relative
interest rate levels by the interested party. It is, in essence, a variation on the old
banking formula:
Principle × rate × time = interest
where the principle is the spot rate, the rate is the interest rate differential, and time is
the maturity in days. Thus:
Spot rate × interest rate differential × days/360 = Pips/points1 + (currency interest rate × days/360)
In other words, the formula for dollars against currency forwards is:
A × D × (B - C)(100 × E) + (C - D)
which equals the number of forward points of spot currency, with 360 day basis,
where:
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A = spot exchange rate
B = currency interest rate
C = dollar interest rate
D = maturity in days
E = day basis
In foreign exchange market forward transaction are necessary for following reasons:
One can hedge or cover an existing future financial, commercial or trade
related exchange risk.
These types of deals, in combination of spot deals, are used for money
market operations through ‘SWAP transactions’.
Taking a view of the market, these can be used for speculation
Forward Sale Contract
FSC is booked for imports into India, remittance of dividend, interest, etc.
Underlying contract can be verified for compliance with exchange/trade
control requirements. If import is under licence, ‘Exchange Control’ copy is to
be obtained and endorsed for having booked forward sale contract.
Necessary approval from RBI for repayment of installments under foreign
currency loan to be verified.
The contract should not exceed the net amount payable overseas.
Substitution of contract is permitted.
Maturity period of FSC should normally be
In the case of import LC Approx. due date of the bill by taking into
consideration date of shipment, postal
transit, usance period etc.
If usance bills under LC are already
received
Due date of the bill
Import collection bill In line with the tenor of the bill. Maximum
6 months from the date of shipment.
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Covering Exchange Risk in Forward Sale contract
Often, the enterprises that are exporting or importing take recourse to covering their
operations in the Forward market. If an importer anticipates eventual appreciation of
the currency in which imports are denominated, he can buy the foreign currency
immediately and hold it up to the date of maturity. This means he has to block his
rupee cash right away. Alternatively, the importer can buy the foreign currency
forward at a rate known and fixed today. This will do away with the problem of
blocking of funds/cash initially. In other words, Forward purchase of the currency
eliminates the exchange risk of the importer as the debt in foreign currency is
covered.
Example
From the data given below calculate forward premium or discount, as the case may
be, of the £ in relation to the rupee.
Spot 1 month forward 3 months forward 6 months forward
Re/£ Rs 77.9542/78.1255 Rs 78.2111/4000 Rs 78.8550/9650
Solution
Since 1 month forward rate and 6 months forward rate are higher than the spot rate,
the British £ is at premium in these two periods, the premium amount is determined
separately both for bid price and ask price. It may be recapitulated that the first quote
is the bid price and the second quote (after the slash) is the ask/offer/sell price. It is
the normal way of quotation in foreign exchange markets.
Premium with respect to bid price
1 month = Rs78.2111 -Rs 77.9542 x 12 x 100 = 3.95% P.a Rs 77.9542 1
6 months = Rs 78.8550 -Rs 77.9542 x 12 x 100 = 2.31% P.a Rs 77.9542 6
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Premium with respect to ask price
1 month = Rs 78.4000 -Rs 78.1255 x 12 x 100 = 4.21% P.a Rs 78.1255 1
6 months = Rs78.9650-Rs 78.1255 x12 x 100 = 2.15% P.a Rs 78.1255 6
Risks involved in Forwards
Because of the time span involved in forward contracts, there can be significant risks,
just as on a spot deal. Credit risk, market/price risk and country risk are all potential
problems. In fact, country risk is more significant than spot trades as unexpected
events in a foreign country are more likely, given the longer period of exposure.
Hence, mainly Banks and Financial Institutions indulge in booking Forward
Contracts.
UBI’s Export Import Performance
PARAMETERSMARCH
06ACTUAL
MAR07
ACTUAL
PROJECTIONMARCH-08
GROWTHAmount &
%
EXPORT CREDIT TERMINAL 5,189 5769.65 70541284(22%)
FOREX TURNOVER 41,285 52254 600007746
(14.82%)
EXPORT 19,458 26938 300003062
(11.37)
IMPORT 11,328 12308 14000 1692(13.75%)
REMITTANCES 10,499 13008 160002992(23%)
NRI DEPOSITS 4,130 4413 57501337(30%)
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Capital Account Convertibility (CAC) of the Indian Rupee
The Capital Account Convertibility refers to the freedom to convert local financial
assets into foreign financial assets and vice versa at the market-determined rate of
exchange. It is associated with changes of ownership in domestic/foreign financial
assets and liabilities and embodies the creation and liquidation of claims on, or by,
the rest of the world.
The currency convertibility on capital account is usually introduced only after the
lapse of certain period of time after the introduction of partial currency convertibility
on Current Account. The Capital Account convertibility can help to increase the inflow
of foreign capital as it enables the foreign investors to repatriate their investments
whenever they want. On the other hand it may also lead to flight of capital from the
country if domestic conditions are unfavorable. Hence Capital Account Convertibility
is usually introduced only after experimenting with the current account currency
convertibility for a reasonable period of time. The country has to see to it that the
stabilization programmers have been successfully carried out and a congenial,
favorable atmosphere is ensured.
The introduction of Capital Account Convertibility (even for certain types of capital
assets) helps to attract resources from abroad. It enables the residents to hold
internationally diversified portfolio investments. However, Capital Account
Convertibility entails the risk of capital flight and greater fluctuations in foreign
exchange rate, foreign exchange reserves and interest rate. Hence till the economy
is well developed the country has to maintain various types of controls. Under free
capital convertibility the residents of the country can sell their property abroad. Hence
even if Capital Account Convertibility is introduced several restrictions have to be
attacked.
Value Added Notes
68
Chapter 5
Risk management in Export finance
PRE-SHIPMENTS FINANCE
Meaning
Also popularly known as Packing Credit, pre shipment finance is advance credit
facility obtained by an exporter from a bank or financial institution .It define as “ any
loan to an exporter for financing the purchase, processing, manufacturing or packing
of goods.”
Features of Pre-shipment Finance
1. Eligibility: As a rule, pre-shipment loan is granted only to those exporters
who actually export and produce a confirmed export order and /or a letter
of credit received in their own names.
2. Purpose: Packing credit is granted for the specific purpose of procuring/
purchasing/ manufacturing/ processing/ storing/ packing and shipping the
goods.
3. Documentary Evidence: Pre-shipment finance is granted against the
evidence of irrevocable L/C established through a reputed bank or against
a confirmed order for export. The document of L/C or confirmed order
must be deposited with the lending institution.
4. Security: The exporter is required to provide personal bond from sureties
known to the bank. Also compulsorily, relevant policy issued by ECGC.
“If you don’t know for sure what will happen, but you know the odds, that is risk. If you don’t even know the odds, that is uncertainty.”
- Frank Knight
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5. Form of Finance: Packing credit can be either in the form of funded or
non-funded advance. Red Clause/Green Clause L/Cs is the forms of
funded finance. Non-funded facilities include domestic L/Cs, back-to-back
L/Cs and various guarantees.
6. Amount of Finance: There is no fixed limit for pre-shipment finance. It
depends on the amount of export order, the credit-rating of the exporter
done by the bank.
7. Term of Credit: Packing credit, being a working capital is basically short
term finance. The maximum period is determined by the RBI. It is
normally granted for a period of 180 days. It can be further extended up to
90 days with prior permission of the RBI.
8. Rate of Interest: The present rates of interest for packing credit are as
under:
Up to 180 days……………….13% per annum
For additional 90 days……….15% per annum
9. Loan Agreement: The exporter has to sign a loan agreement with the
bank in order to get packing credit.
10. Monitoring the use of Loan: The lending bank monitors the use of
finance by the exporter to ensure that the amount is used for export
purpose only. The bank can impose penalty for misuse.
11. Repayment/ Liquidation of Loan: The exporter should repay the amount
of packing credit out of the proceeds of export bill.
METHODS/ TYPES/ FORMS OF PRE-SHIPMENT FINANCE
i. Extended Packing Credit Loan: This facility, though for a short period, is
granted to those exporters who are rated first class by the bank. Loan is
granted for making advance payment to suppliers for acquiring exportable
goods.
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ii. Packing Credit Loan (Hypothecation): In this case packing credit is
extended for obtaining raw materials, work-in-process and / or finished goods.
The goods acquired are treated as security for the loan granted.
iii. Packing Credit Loan (Pledge): This facility is available for seasonal goods
or those acquired by the exporter under odd lots.
iv. Security Shipping Loan: Once the raw material is converted in to finished
goods, the same has to be handed over to transport operator or to the
clearing and forwarding agent. The security loan can be obtained only after
this.
v. Advances against Back-to-Back Letter of Credit: An exporter, who has
received original letter of credit from importer, requests his banker to open a
letter of credit in favor of his supplier.
vi. Advances against Red Clause L/C: When the exporter receives red clause
L/C from the importer, it authorizes the exporter’s bank to provide advances
to complete production.
vii. Advances against Export Incentives: Advances against export incentives
such as DBK is provided by the bank both at pre-shipment and post-shipment
stage.
viii. Packing Credit for Imports against Advance License Entitlement: This
credit facility is available to manufacturer exporters who are not in receipt of
letter of credit or confirmed export order. Finance is made available for
imports against license for manufacture of export goods.
ix. Advance against Cheques, Drafts etc.: Banks provide export credit at
concessional rate against the proceeds of cheques, drafts etc. received
directly towards advance payments for exports.
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POST-SHIPMENT FINANCE
The Reserve Bank of India defines post-shipment as “any loan or advance granted or
any credit provided by a bank to an exporter of goods from India from the date
extending the credit after shipment of the goods to the date of realization of the
export proceeds.”
FEATURES OF POST-SHIPMENT FINANCE:
a) Forms of Post-shipment Finance: Banks provide post-shipment finance
under different forms such as:
Discounting of Export Bill
Advance against goods sent on Consignment Basis.
Advance against Retention Money etc.
b) Amount of Finance: The amount of post-shipment finance can be to the
extent of 100% of invoice value of goods. It depends on short term, medium
term and long term finance. It also depends on the value of capital goods and
equipment or the value of turnkey projects. Any loan up to Rs. 10 crores for
financing export of capital goods is decided by a commercial bank which can
get refinanced itself by the EXIM Bank. In a contract above Rs. 10 crores but
not more than Rs. 50 crores, the EXIM Bank decides whether the facility can
be given. Contracts above Rs. 50 crores need clearance from the Working
Group on Export Finance, consisting of the representatives of EXIM Bank,
RBI ECGC and Exporter’s Bankers. In case of large contracts,
representatives of the Ministries of Commerce and Finance are also members
of the Working Group.
c) Period of Finance: The period of loan depends on:
Short-term: The loan is provided by commercial banks
usually for 90 days.
Medium-term: Commercial banks together with EXIM
Bank provide medium term finance for a period between 90
days and 5 years.
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Long-term: It is provided by EXIM Bank in case of export
of capital goods and turnkey projects for a period
exceeding 5 years.
d) Rate of Interest: Post-shipment finance facility is granted at a concessional
rate of 13% p.a. for a period between 90 days. For medium term and long
term loans the rates of interest are applicable as per the directives of RBI
issued for time to time.
e) Loan Agreement: The exporter is required to execute a formal loan
agreement with the bank before the amount of loan is actually disbursed.
f) Maintenance of Accounts: As per the RBI directives, banks must maintain a
separate account in respect of each post-shipment advance.
g) Disbursement of Loan Amount: Normally, post-shipment credit advances
are not given in lump sums. It is disbursed in installments as and when
required by the concerned exporter.
h) Monitoring the use of Advances: The bank advancing post-shipment credit
facility should monitor the use of finance to ensure that it is used for export
purpose only. Penalty can be imposed for misuse.
i) Repayment/Liquidation of Advances: The exporter is expected to repay the
amount of loan to the bank as soon as he receives export proceeds.
Generally, the lending bank itself realizes the export proceeds from the
importer’s bank.
METHODS/ TYPES / FORMS OF POST-SHIPMENT FINANCE:
I) Export Bills negotiated under L/C: An exporter can avail of post-shipment
credit by drawing bills or drafts under the L/C. The bank insists on
production of the necessary documents as stated in the L/C. If documents
are in order, the bank negotiates the bill and advance is granted to the
exporter.
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II) Purchase/ Discounting of Export Bills under Confirmed Orders: If L/C is
not available as security; bank financing depends upon the credit-
worthiness of the exporter. At the request of the exporter, the bank will
purchase or discount the export bill and pay the equivalent rupees to the
exporter.
III) Advances against Bills sent for Collection: Advances against such bills
that are sent for collection is granted under a separate account called
‘post-shipment loan’. This type advance is not very popular.
IV) Advance against Goods sent on Consignment Basis: An exporter may
send goods to his foreign agent on consignment basis. Post-shipment
finance in this case is subject to the customer enjoying specific credit limit
fixed by the bank. Advances are given against the documents of
consignment. These documents are forwarded by the overseas bank to
the importer only against a Trust Receipt. The Trust Receipt is the
undertaking given by the agent abroad to send the amount of sale
proceeds by a specified date.
V) Advance against Duty Drawback Entitlement: DBK or drawback means
refund of custom duties paid on the import of raw materials, components
and packing material used for export products. Banks offer pre-shipment
advances against DBK entitlements.
VI) Advance against Undrawn Balance of Bills: In some cases bills are not
drawn for the full invoice value of goods. Certain amount remains
undrawn, which is due for payment after adjustments on account of
differences in rates, weight, quality etc. to be ascertained after inspection
and approval of the goods. Banks offer advances against such undrawn
balances up to 5% of the value of export on an undertaking from the
exporter to surrender the balance proceeds to the bank.
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VII)Advances against Retention Money: In respect of certain exports of capital
goods and project exports, the importer retains a part of the price towards
guarantee of performance or completion of the project. Bank provide
advance against such retention money. The advance is repayable within
one year from the date of shipment or when the importer releases the
payment of retention money, whichever is earlier.
VIII) Advance against Deemed Exports: Certain specific sales or supplies
made in India are considered as ‘Deemed Exports’ although they are not
exports in real sense, such as sales to foreign tourists during their stay in
India and supplies made in India to IBRD/ IDA/ ADB aided projects. Credit
is given for maximum of 30 days in case of such Deemed Exports.
IX) Advances against Deferred Payments: In case of project exports or
large-scale construction contracts, the exporter receives payment from
the importer in statements spread over a period of time. Commercial
banks together with the EXIM Bank offer advances against Deferred
Payment at concessional rates of interest for 180 days.
Risk Management tools used
The Whole Turnover Packing Credit Guarantee Scheme was introduced in the year
1969 with a view to providing guarantee cover on all India basis for shipment
advances granted by banks.
UBI entered into a contract with ECGC seeking cover against losses that may be
sustainable granting pre-shipment advances to the exporters. This guarantee is
issued for period of one year(commencing from the month of July to the month of
June in the succeeding year.)
ECGC while extending the guarantee fixes maximum liability i.e. the amount up to
which the claims will be paid to the bank under this guarantee.
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Types of Risks Covered
The following risks are covered under the guarantee in respect of losses, which may
be incurred after granting Packing Credit Advances to exporter clients.
a. Insolvency of the exporter
b. Protracted default by the exporter to pay the amounts due to the
Bank.
The Following advances are covered under this guarantee
Packing Credit Advances granted for import of goods under a L/C in respect
of export obligation.
Packing Credit against LC/ orders
Packing Credit to manufacturers for orders received from export
Houses(EH) / Trading Houses(TH)/ Star Trading Houses (STH), Super Star
Trading Houses
Packing Credit to sub suppliers
Packing Credit to deemed exports.
WTPCG does not cover advances granted:
1. To Public Sector Undertakings owned by the government of India minimum
holding of the government should be to the extent of 51%.
2. For exports made on deferred terms of payment, turnkey projects,
construction works and service contracts.
3. Against duty drawback:/cash assistance.
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UBI & ECGC
Details of settlement of claims.
Year No. of cases Amt. (Rs in crs.)
2003 - 04 35 14.18
2004 - 05 21 5.75
2005 – 06 32 23.63
2006- 07 13 8.98
Claims pending 31.03.07
WTPCG 14 8.62
WTPSG 8 9.41
Forward Purchase Contract
An exporter can eliminate the risk of currency fluctuation by selling his receivables
forward.
FPC is booked against export of goods and services/ receipt of foreign
exchange by a forward remittance conversion of EEFC or FCNR deposits.
Underlying contract to be verified for compliance with the exchange
control/trade control regulations like for example – delivery period of contract
should not exceed 6 months from the date of shipment.
A single contract can be booked for different export orders in the same
currency and at appropriate tenor, if the payments are all being received by
one bank.
Substitution of export order can be allowed if shipment against the original
order is not made.
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SWAPs as a Risk Management tool
Swaps involve exchange of a series of payments between two parties. Normally, this
exchange is effected through an intermediary financial institution. Though swaps are
not financing instruments in themselves, yet they enable obtainment of desired form
of financing in terms of currency and interest rate. Swaps are over-the-counter
instruments.
The market of currency swaps has been developing at a rapid pace for the last fifteen
years. As a result, this is now the second most important market after the spot
currency market. In fact, currency swaps have succeeded parallel loans, which had
developed in countries where exchange control was in operation. In parallel loans,
two parties situated in two different countries agreed to give each other loans of
equal value and same maturity, each denominated in the currency of the lender.
While initial loan was given at spot rate, reimbursement of principal as well as
interest took into account forward rate.
However, these parallel loans presented a number of difficulties. For instance, default
of payment by one party did not free the other party of its obligations of payment. In
contrast, in a swap deal, if one party defaults, the counterparty is automatically
relived of its obligation.
Currency swaps can be divided into 3 categories:
(a) fixed-to-fixed currency swap,
(b) floating-to-floating currency swap,
(c) fixed-to-floating currency swap.
A fixed-to-fixed currency swap is an agreement between two parties who exchange
future financial flows denominated in two different currencies. A currency swap can
be understood as a combination of simultaneous spot sale of a currency and a for-
ward purchase of the same amounts of currency. This double operation does not
involve currency risk. In the beginning of exchange contract, counterparties
exchange specific amount of two currencies. Subsequently, they settle interest
according to an agreed arrangement. During the life of swap contract, each party
pays the other the interest streams and finally they reimburse each other the principal
of the swap.
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A simple currency swap enables the substitution of one debt denominated in one
currency at a fixed rate to a debt denominated in another currency also at a fixed
rate. It enables both parties to draw benefit from the differences of interest rates
existing on segmented markets. A similar operation is done with regard to floating-to-
floating rate swap.
A fixed-to-floating currency coupon swap is an agreement between two parties by
which they agree to exchange financial flows denominated in two different currencies
with different type of interest rates, one fixed and other floating. Thus, a currency
coupon swap enables borrowers (or lenders) to borrow (or lend) in one currency and
exchange a structure of interest rate against another-fixed rate against variable rate
and vice versa. The exchange can be either of interest coupons only or of interest
coupons as well as principal. For example, one may exchange US dollars at fixed
rate for French francs at variable rate. These types of swaps are used quite
frequently.
Important Features of Swap contracts
Minimum size of a swap contract is of the order of 5 million US dollar or its equivalent
in other currencies. But there are swaps of as large a size as 300 million US dollar,
especially in the case of Eurobonds. The US dollar is the most sought after
currencies in swap deals. The dollar-yen swaps represent 25 per cent of the total
while dollar-deutschemark account for 20 per cent of the total. The swaps involving
Euro are also likely to be widely- prevalent in European countries.
Reasons for Currency Swap Contracts
At any given point of time, there are investors and borrowers who would like to
acquire new assets/liabilities to which they may not have direct access or to which
their access may be costly. For example, a company may retire its foreign currency
loan prematurely by swapping it with home currency loan. The same can also be
achieved by direct access to market and by paying penalty for premature payment. A
swap contract makes it possible at a lower cost. Some of the significant reasons for
entering into swap contracts are given below.
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Hedging Exchange Risk
Swapping one currency liability with another is a way of eliminating exchange rate
risk. For example, if a company (in UK) expects certain inflows of deutschemarks, it
can swap a sterling liability into deutschemark liability.
Differing Financial Norms
The norms for judging credit-worthiness of companies differ from country to country.
For example, Germany or Japanese companies may have much higher debt-equity
ratios than what may be acceptable to US lenders. As a result, a German or
Japanese company may find it difficult to raise a dollar loan in USA. It would be much
easier and cheaper for these companies to raise a home currency loan and then
swap it with a dollar loan.
Credit Rating
Certain countries such as USA attach greater importance to credit rating than some
others like those in continental Europe. The latter look, inter-alia, at company's
reputation and other important aspects. Because of this difference in perception
about rating, a well reputed company like IBM even-with lower rating may be able to
raise loan in Europe at a lower cost than in USA. Then this loan can be swapped for
a dollar loan.
Market Saturation
If an organization has borrowed a sizable sum in a particular currency, it may find it
difficult to raise additional loans due to 'saturation' of its borrowing in that currency.
The best way to tide over this difficulty is to borrow in some other 'unsaturated'
currency and then swap. A well-known example of this kind of swap is World Bank-
IBM swap. Having borrowed heavily in German and Swiss market, the WB had
difficulty raising more funds in German and Swiss currencies. The problem was
resolved by the WB making a dollar bond issue and swapping it with IBM's existing
liabilities in deutschemark and Swiss franc.
Parties involved
Currency swaps involve two parties who agree to pay each other's debt obligations
denominated in different currencies. The below example illustrates currency swaps:
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Example
Suppose Company B, a British firm, had issued £ 50 million pound-denominated
bonds in the UK to fund an investment in France. Almost at the same time, Company
F, a French firm, has issued £ 50 million of French franc-denominated bonds in
France to make the investment in UK. Obviously, Company B earns in French franc
(Ff) but is required to make payments in the British pound. Likewise, Company F
earns in pound but is to make payments in French francs. As a result, both the
companies are exposed to foreign exchange risk.
Foreign exchange risk exposure is eliminated for both the companies if they swap
payment obligations. Company B pays in pound and Company F pays in French
francs. Like interest rate swaps, extra payment may be involved from one company
to another, depending on the creditworthiness of the companies. It may be noted that
the eventual risk of non-payment of bonds lies with the company that has initially
issued the bonds. This apart, there may be differences in the interest rates attached
to these bonds, requiring compensation from one company to another.
Example 2
Consider an American-based company that has raised money by issuing a Swiss
franc-denominated Eurobond with fixed semi-annual coupon payments of 6% on 100
million Swiss francs. Up front, the company receives 100 million Swiss francs from
the proceeds of the Eurobond issue. In essence, they are using the Swiss francs to
fund their American operations.
Because this issue is funding American-based operations, the company is going to
have to convert the 100 million Swiss francs into dollars. This can be done by
entering into a currency swap whereby the Swiss franc debt can be converted into a
dollar like debt.
The American company can agree to exchange the 100 million Swiss francs at
inception into dollars, receive the Swiss franc coupon payments on the same dates
as the coupon payments are due to the company’s Eurobond investors: pay dollar
coupon payments tied to a preset index and re-exchange the dollar notional into
Swiss francs at maturity.
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The Stages in a Currency Swap
82
Value Added Notes
Relief to Exporters for a While
INR appreciating more than 10% was hurting exporters a lot. Because the exporters
had contracts in USD while there operating expenses were in INR due to which
expenses remained the same but when they earned and converted USD into INR
they received much less due to which their margins got squeezed.
But then steps were taken to relieve exporters. The DEPB (Duty Entitlement Pass
Book) scheme which was going to be expiring on 31st march, 2007 has been
extended till May, 2009. It is likely that the scheme would continue till the
implementation of a uniform goods and services tax (GST). The GST is likely to be
put in place by 2010. Some price sensitive products like Basmati rice, steel and
cement would, however, not be entitled for the benefits under the scheme. Their
exclusion is aimed towards curtailing inflation which has touched a year high of
11.91% for the week ended July 05, 2008.
DEPB is the most popular scheme among the exporters because of the fact that
under the scheme traders can import the raw material and equipment at a reduced
rate and show the obligatory export latter. The government wants the scheme to be
replaced by the duty drawback scheme under which the traders would first pay all
the required taxes and get the drawback after showing proof of mandatory exports.
Denting margins of exporters because of sharp appreciation in rupee versus the
greenback in the last 12 months coupled with political pressure and ensuing general
election next year has led to the continuation of the scheme during the current fiscal.
In addition, the Government has decided to pay 6% interest to exporters on delayed
refund of terminal excise duty and CST as this would go a long way in getting timely
refund to exporters.
Besides this step, exchange rate is also now in a range of Rs.42.00-42.50/USD
adding to the relief of the exporter.
83
Chapter 6
Risk Management in Issuing Guarantees
Guarantees
A bank guarantee is a written contract given by a bank on the behalf of a customer.
By issuing this guarantee, a bank takes responsibility for payment of a sum of money
in case, if it is not paid by the customer on whose behalf the guarantee has been
issued. In return, a bank gets some commission for issuing the guarantee.
Any one can apply for a bank guarantee, if his or her company has obligations
towards a third party for which funds need to be blocked in order to guarantee that
his or her company fulfils its obligations (for example carrying out certain works,
payment of a debt, etc.).
In case of any changes or cancellation during the transaction process, a bank
guarantee remains valid until the customer dully releases the bank from its liability.
In the situations, where a customer fails to pay the money, the bank must pay the
amount within three working days. This payment can also be refused by the bank, if
the claim is found to be unlawful.
"To assure that you will never experience failure: · don't take a risk, · don't attempt anything new, · don't expand on your ideas, · don't set goals. Never to do any of these things actually guarantees you will fail.
- Catherine Pulsifer, from Failure Is A Golden Opportunity
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Benefits of Bank Guarantees
For Governments:
1. Increases the rate of private financing for key sectors such as infrastructure.
2. Provides access to capital markets as well as commercial banks.
3. Reduces cost of private financing to affordable levels.
4. Facilitates privatizations and public private partnerships.
5. Reduces government risk exposure by passing commercial risk to the private
sector.
For Private Sector:
1. Reduces risk of private transactions in emerging countries.
2. Mitigates risks that the private sector does not control.
3. Opens new markets.
4. Improves project sustainability.
Legal Requirements
Bank guarantee is issued by the authorized dealers under their obligated authorities
notified vide FEMA 8/ 2000 dt 3rd May 2000. Only in case of revocation of guarantee
involving US $ 5000 or more need to be reported to Reserve Bank of India (RBI).
Types of Bank Guarantees
1. Direct or Indirect Bank Guarantee: A bank guarantee can be either direct or
indirect.
Direct Bank Guarantee: It is issued by the applicant's bank (issuing bank)
directly to the guarantee's beneficiary without concerning a correspondent
bank. This type of guarantee is less expensive and is also subject to the law
of the country in which the guarantee is issued unless otherwise it is
mentioned in the guarantee documents.
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Indirect Bank Guarantee: With an indirect guarantee, a second bank is
involved, which is basically a representative of the issuing bank in the country
to which beneficiary belongs. This involvement of a second bank is done on
the demand of the beneficiary. This type of bank guarantee is more time
consuming and expensive too.
2. Confirmed Guarantee
It is cross between direct and indirect types of bank guarantee. This type of
bank guarantee is issued directly by a bank after which it is send to a foreign
bank for confirmations. The foreign banks confirm the original documents and
thereby assume the responsibility.
3. Tender Bond
This is also called bid bonds and is normally issued in support of a tender in
international trade. It provides the beneficiary with a financial remedy, if the
applicant fails to fulfill any of the tender conditions.
4. Performance Bonds
This is one of the most common types of bank guarantee which is used to
secure the completion of the contractual responsibilities of delivery of goods
and act as security of penalty payment by the Supplier in case of nondelivery
of goods.
5. Advance Payment Guarantees
This mode of guarantee is used where the applicant calls for the provision of
a sum of money at an early stage of the contract and can recover the amount
paid in advance, or a part thereof, if the applicant fails to fulfill the agreement.
6. Payment Guarantees
This type of bank guarantee is used to secure the responsibilities to pay
goods and services. If the beneficiary has fulfilled his contractual obligations
after delivering the goods or services but the debtor fails to make the
payment, then after written declaration the beneficiary can easily obtain his
money form the guaranteeing bank.
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7. Loan Repayment Guarantees
This type of guarantee is given by a bank to the creditor to pay the amount of
loan body and interests in case of non fulfillment by the borrower.
8. B/L Letter of Indemnity
This is also called a letter of indemnity and is a type of guarantee from the
bank making sure that any kind of loss of goods will not be suffered by the
carrier.
9. Rental Guarantee
This type of bank guarantee is given under a rental contract. Rental
guarantee is either limited to rental payments only or includes all payments
due under the rental contract including cost of repair on termination of the
rental contract.
10. Credit Card Guarantee
Credit card guarantee is issued by the credit card companies to its customer
as a guarantee that the merchant will be paid on transactions regardless of
whether the consumer pays their credit.
How to Apply for Bank Guarantee
Procedure for Bank Guarantees is very simple and is not governed by any particular
legal regulations. However, to obtained the bank guarantee one need to have a
current account in the bank. Guarantees can be issued by a bank through its
authorized dealers as per notifications mentioned in the FEMA 8/2000 date 3rd May
2000. Only in case of revocation of guarantee involving US $ 5000/ or more to be
reported to Reserve Bank of India along with the details of the claim received.
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Bank Guarantees vs. Letters of Credit: - A bank guarantee is frequently confused
with letter of credit (LC), which is similar in many ways but not the same thing. The
basic difference between the two is that of the parties involved. In a bank guarantee,
three parties are involved; the bank, the person to whom the guarantee is given and
the person on whose behalf the bank is giving guarantee. In case of a letter of credit,
there are normally four parties involved; issuing bank, advising bank, the applicant
(importer) and the beneficiary (exporter).
Also, as a bank guarantee only becomes active when the customer fails to pay the
necessary amount where as in case of letters of credit, the issuing bank does not
wait for the buyer to default, and for the seller to invoke the undertaking.
UBI – An overview of issued L/Cs and L/Gs
Sr Particulars Letters of Guarantees Letters of Credits2007-08 2006-07 2005-06 2007-08 2006-07 2005-06
1. Nos. issued 18915 22341 17585 15665 15962 172772. Amount (Rs.
In Crores)4452 4041 4195 12810 8508 8938
3. Nos. invoke/ Devolved
229 213 176 1488 1883 1466
4. Amount (Rs. In Crores)
59 237 35 553 663 705
5. % invoked/ devolved
1.33 5.86 0.83 4.32 7.79 7.89
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Risk Management Tools used
Export Performance Guarantee provides cover to the Bank against the risk of loss
involved in issuing the below types of guarantees:
1. Bid Bond or Bid Guarantee which is required to be submitted along with the
bids for export contracts;
2. Performance Bond or Performance Guarantee which is issued favoring the
foreign buyer for due performance of the contract;
3. Advance Payment Guarantee which is issued favoring foreign buyer against
advance payment received from the buyer;
4. Retention Money Guarantee issued favoring the foreign buyer in lieu of his
retaining a portion of each payment as Retention Money;
5. Guarantee issued to an overseas bank for the purpose of enabling the
foreign bank to extend foreign currency loan/OD to the Indian exporter for the
purpose of executing an export contract;
6. Guarantee issued to customs authorities in India in lieu of customs duty
payable on imported raw materials or components meant for manufacturing
goods for export;
7. Guarantee issued to Import Control Authorities in India in support of export
undertakings given by the exporter who gets advance import licence;
8. Guarantee issued to Sales Tax Authorities in lieu of payment of sales tax on
goods meant for export;
9. Guarantee issued to Export Promotion Councils against allotment of export
quota.
For the purposes of EPG, a loss will be deemed to have arisen when the bank is
unable to recover from the exporter the money that bank has paid to the beneficiary
of the guarantee. In other words, the Bank will have to establish that:
(a) The guarantee was invoked by the beneficiary
(b) The amount demanded by the beneficiary was paid by it strictly in
accordance with the guarantee;
(c) The exporter was called upon to reimburse the bank with the said amount
and
(d) The exporter has failed to discharge the debt so created.
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Risks Covered
The risk insured under the EPG are
(i) Insolvency of the exporter and
(ii) His protracted default.
Buyer’s Credit
In the usual practice, an importer requests his bank to open a Letter of Credit. When
the L/C is honored i.e. when the importer’s bank makes payment on behalf of the
importer, the importer reimburses the money so paid by the importer’s bank.
However, in the case of Buyer’s Credit, the importer requests L/C opening bank to
pay the dues on behalf of the importer. Thus this is a form of credit facility given to
the importer.
Steps involved in Buyer’s Credit
1. Importer requests for arranging buyer’s credit. He will execute necessary
documentation favoring the bank.
2. The bank arranges an External Commercial Borrowing with one of the banks
abroad with whom the bank has tie up. For this, the bank will provide an
undertaking to make payment on the new due date. Technically, the bank
abroad treats this as a credit facility provided to the bank extending the credit
facility. It is not concerned with the importer.
3. The Bank credits the funding Bank’s nostro account, and in turn, the bank
pays off the exporter (or the negotiating bank).
4. For all practical purposes, the L/C gets extinguished. The books of the bank
funding the Buyer’s credit should show this liability as a contingent liability on
account of the buyer’s credit.
5. On the new due date, importer pays the funding bank. With this, the
transaction gets closed.
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Value Added Notes
How the importers use this tool for their own advantage?
Suppose the maturity date of the contract in USD has arrived i.e. 180 days are over.
Now the importer has to make payment to the exporter. He goes to his bank to avail
of buyer’s credit facility.
Bank will generally demand 100% margin for availing such facility. It means that the
overseas bank will make the payment now at the guarantee of importer’s bank. So
for the time being nostro a/c of importer’s bank will be credited and payment will be
made to the exporter through exporter’s bank.
So exporter will not know from where the funds are coming. So the transaction
between exporter and importer is completed. But the transaction between the
importer, his bank and the overseas bank is not yet completed.
So what this all means is that:
Importer has borrowed money in terms of USD at Libor rates of interest which is
currently 4-5% from the overseas bank for a period of 180 days. While the importer
will get 8-9% interest on the margin which he has kept with his bank. So he will be
making profit from such transaction.
But the risk he faces is of exchange rate. So he will have to book forward and
hedge his exposure.
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On the Maturity Date (buyer’s credit)
Importer’s bank
Exporter’s bank
Importer
Overseas Bank
Exporter
Credits its nostro A/c
Payment
100% margin + interest on BF
Receives interest on margin amount Payment
After 180 days of maturity Loan amount payment with interest
92
Chapter 7
Risk Management in Granting Advances
INTRODUCTION:
A bank’s job is to accept deposits and lend. It earns through the spread between the
rate at which it lends and the rate at which it accepts deposits.
So in granting advances the main risk that it faces is the Credit Risk. So, our main
concern in this chapter, here, would be Credit risk itself and models used for
quantifying it.
Managing Credit Risk has always been the most risky business in the Financial
Services Industry. If we look back into the past, we will find that poor management of
Credit Risk was the root cause behind most of the major Banking disasters. Being
the oldest risk in the market, it was not given much attention and almost remained
aloof to the advent of technology until the late 1990s. With the introduction of banking
regulations, there is awareness in the industry now to identify measure, monitor and
control Credit Risk as well as to determine that they hold adequate capital against
this risk. Credit risk not only affects the lenders but also any company that receives
funds for products or services.
As the market has turned increasingly competitive with the mushrooming of new
players, it is quite evident that companies are taking on more credit risk. But for a
more transparent market and healthy competition, the Financial Services Industry
must turn Credit Risk into an opportunity. The Financial Services Industry must
manage credit risk at both individual and portfolio levels. However, individual
management of credit risk requires relevant and specific knowledge of the
counterpart's business and financial status. The Financial Service Organizations
have gained considerable experience in the evaluation of credit defaults by using
models and the advanced risk management methods.
“Risk comes from not knowing what you`re doing.”
- Warren Buffet
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Over the years, these models have evolved significantly and today they are accepted
by the industry as stable and accurate. The sad part of the story is that the operation
of these models requires a huge amount of data.. Thus, it is likely that only large
banks will be capable of using the advanced risk management practices laid down by
Basel II.
The internal ratings-based (IRB) requirements of Basel II are quite painstaking and
once a bank elects to use the IRB approach in one portion of its loan book, it must do
so for all of its loans. This universal application will challenge most banks because
they typically run their lending businesses by department or branch.
While the industry has made rapid progress in solving the individual aspects of the
Credit Risk Management problem, a consistent strategy to manage all sources of
credit risk has not been taken up. Even the biggest Financial Organizations are yet to
integrate disparate components of credit risk for an enterprise-wide Credit Risk
Framework.
The following is one of the models used to quantify the credit risk involved and
provides a Credit rating for the client and the interest rate to be charged to the client
is based on the rating outcome.
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Rating Model
Applicable for sanctions above Rs. 10 crores
(Fund based and non fund based)
Investment grade Non investment gradeCredit quality
Rating Numeric
Aggregate Score
Credit Quality
Rating Numeric
Aggregate Score
Lowest risk CR 1 >90 High risk CR 6 61 – 70Low risk CR 2 86 – 90 Higher risk CR 7 51 – 60Medium risk
CR 3 81 – 85 Highest risk
CR8 50 & below
Satisfactory risk
CR 4 76 – 80 Default grade
CR 9
Fair risk CR 5 71 – 75
Default grade means a stage once the account enters into a NPA category.
1. RATING OF THE BORROWER
No. Parameter Parameter criterion Score MaxA. Financial risk
1. Debt equity ratio
Below 11 to 1.5
1.5 to 2.52.5 & above
3210
3
2. Ratio to total outside liability to tangible net worth
1.5& below1.5 to 2.52.5 to 4Above 4
3210
3
3. Current ratio 1.5 & above1.33 to 1.51.17 to 1.331 to 1.17Less than 1
54321
5
4. ROCENPAT/TNW + LT liabilities
Above 15%>12% to 15%>10% to 12%>8% to 10%Less than 8%
43210
4
5. Net salesActual vis-à-vis Projections
100% & above>80%<100%>60%<80%Below 50%
3210
3
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6. Interest service coverage ratio
More than 2.52 to 2.51.99 to 1.5Less than 1.5
3210
3
7. Debt service coverage ratio
>2>1.5 to 2>1.1 to 1.5<1.1
3210
3
8. Growth in net sales
>20%>15%<20%>10%<15%Less than 10%
3210
3
9. Growth in net profit
>20%>15%<20%>10%<15%Less than 10%
3210
3
Sub total 30
Additional 2 parameters based on Cash Flow StatementA Net cash from
operations to sales
>5%>3% to 5%0 to 3%Negative
3210
3
B Net cash from operations to long term debts
Above 40%Between 25% to 40%Between 10% to 25%Below 10%
3210
3
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B. Management RiskI. Management
ExperienceVery high > 5 yearsHigh ( 2 to 5 years )Moderate (> 2 years)Absent ( 0 years )
3210
3
II. Management Initiatives
HighModerateLow
210
2
III. Honoring Financial Commitments
Honored on timeHonored but delayed within acceptable periodHonored but delayed beyond acceptable periodNot honored
32
10
3
IV. Concentration of management
Team of qualified professionalMgt. concentrated in few handsBusiness dependent on 1 or 2 individuals
210
2
V. Labor management in the past
Very goodCordialinadequate
210
2
VI. Affiliate Concerns Performance
AbsentPresent
20
2
VII. Market reputation of the promoters/ management
Excellent imageNo adverse factors
21
2
VIII. Ability of the promoters/ mgt. to bail out the company in case of crisis
YesNo
10
1
IX. Succession planning in key business areas
Yes No
10
1
X. Balance sheet practices Unqualified report for the past 3 yrs.Unqualified report for past 2 yrs.Other cases
2
1
0
2
XI. Statutory compliancea) Pollution Board
b) Environmental clearance
c) Sales tax – income tax no.
d) Export/import code (list only illustrative)
Complied withNot complied with
20
2
Sub total 22
97
C. Industry risk
1. Market potential/ demand situation
GoodNeutralUnfavorable
210
2
2. Diversification among different consumer segments
High Moderatelow
210
2
3. Competitive situation
Monopoly situationFavorableNeutralUnfavorable
3210
3
4. Inputs/ raw material availability
HighModerate Low
210
2
5. Locational issues FavorableNeutralUnfavorable
210
2
6. Technology Superior AdequateLow
210
2
7. Manufacturing efficiency/capacity utilization
GoodSatisfactoryAverageBelow average
3210
3
8. Cyclicality/ seasonality
Not affected by cyclical fluctuationsFavorable industry cycle with long term prospectsSusceptible to unfavorable changes in the markets/ industry cycle
2
1
0
2
Sub total 18
98
Summary
Borrower Rating
No. of parameters MarksA. Financial aspects 10 30
B. Management risk 10 22
C. Market/industry risk
8 18
Sub total 28 70D. Cash flow related
parameters2 6
Total 30 76
2. RATING OF THE FACILITY
A. Compliance of sanction terms
1. Compliance of sanction terms
All sanction terms complied withOnly 2nd charge not registeredEM not completed
210
2
2. Submission of stock statements
Timely submissionSubmitted within 30 days from due dateBelated submission beyond 30 days
210
2
3. Submission of audited balance sheet & profit & loss A/c
Submitted within 3 monthsBetween 3 and 6 months fromDelay > 6 months(From closure of the A/c)
210
2
4. Repayment schedule for term loans only
Up to 5 yearsMore than 5 years
21
2
5. Operations in the account
Turnover commensurate with salesTurnover > 70% to < 90%Turnover > 60% to < 70%Turnover < 60 %
3210
3
6. Operations in the account
Top class – no occasion of excess and return of chequesSatisfactory – rare occasionsAverage – Occasional Below average - Frequent
3210
3
99
7. Commitments under term loan and payment on interest on cash credit/ overdraft etc.
Timely paymentIrregular up to 1 month from due dateIrregular beyond 1 month up to 2 monthsDelayed beyond 2 months
32
1
0
3
8. Margin given on term loan
> 40% margin> 25% to < 40% margin20% to < 25%< 20 %
3210
3
Sub total 20
III. BUSINESS CONSIDERATIONS1. Length of relationship > 5 years
1 – 5 years< 1 year
210
2
2. Income value to the bank from the account as %age to total fund based limits
> 10%> 8% - 10%< 8%
210
2
Sub total 4
SUMMARY
MarksI. Rating of the Borrower 70
Cash Flow related Parameters 6II. Rating of the facility 20
III. Business Aspects 4
TOTAL 100
Note: The total score under the model is 100. When one or more parameters are not applicable, the score obtained under the applicable parameters should be converted into% terms and appropriate grade/ rating is assigned.
100
This is how the banks quantify the credit risk involved. The above model includes
both qualitative and quantitative data and the financial data used is certified by a
registered Chartered Accountant. This credit rating is generally done on a yearly
basis. So every year the credit rating of a firm may improve or deteriorate.
And on this credit rating interest rate to be charged, the limits for L/C, L/G, pre-
shipment finance and post shipment finance is based. So as the credit rating goes
down, the interest to be charged to the business increases.
For the above credit rating model the financial indicators which come into
picture are as follows:
Year Ending 31.3.2006(Aud.)
31.3.2007(Aud.)
31.3.2008(Aud/ Prov)
31.3.2009(Est.)
Paid up CapitalReserves & SurplusIntangible AssetsTangible Net WorthLong Term LiabilitiesCapital EmployedNet BlockInvestmentsNon Current AssetsNet Working CapitalCurrent AssetsCurrent LiabilitiesCurrent RatioDebt Equity RatioDER (TOL/TNW)Net Sales Other IncomeNet Profit Before taxNet Profit After TaxDepreciationCash Accruals
101
The company may apply for a loan of any amount but one of the way through
which bank fixes this loan amount is as follows:
Total Current Assets. Less: Current Liabilities (Other than Bank Borrowings)Working Capital Gap. NWC Flexible Bank Balance (FBF)Net SalesNWC to TCA %Flexible Bank Finance to TCA %Sundry Creditors to TCA %
The flexible bank finance (FBF) is the amount which gets sanction as a loan (WC
term loan). If additional amount is required by the firm it will have to provide a
security for it.
Though looks simple, but it requires a lot of documentation and hard work to get the
sanction of the loan from the bank.
Value Added Notes
The format for granting advances is available in the CD attached to this book. It will
give the reader an idea what are the requirements that he/she will have to satisfy.
After granting the loan too, the borrower will have to furnish all the data the lender
(bank) requires.
102
Chapter 8
Interest Rate Volatility and its impact on Profitability – a GAP Analysis
The acceptance and management of financial risk is inherent to the business of
banking and banks’ roles as financial intermediaries. To meet the demands of their
customers and communities and to execute business strategies, banks make loans,
purchase securities, and take deposits with different maturities and interest rates.
These activities may leave a bank’s earnings and capital exposed to movements in
interest rates. This exposure is interest rate risk.
Why are the interest rates so volatile in India?
Inflation touching historical heights of 2 digits i.e. 11.42. This means that the
real interest rate is negative in India.
Real Interest rate = Nominal Interest rate – Inflation rate
That implies that though they may be keeping deposits with the banks and
earning interest of 5-6% but their deposit is still getting eroded in terms of
value making the banks think of increasing the deposit rates.
RBI has a job to do i.e. to curb inflation for which it has taken broad steps of
increasing the repo rate to 8.5% and the CRR ratio to 8.75% to suck the
liquidity from the market through banks so that inflation can be controlled.
Repo rate is the discount rate at which a central bank repurchases
government securities from the commercial banks, depending on the
level of money supply it decides to maintain in the country's monetary
system. To temporarily expand the money supply, the central bank
decreases repo rates (so that banks can swap their holdings of
government securities for cash), to contract the money supply it
increases the repo rates.
“Even a correct decision is wrong when it was taken too late.”
- Lee Iacocca
103
In terms of Section 42(1) of the RBI Act 1934, Scheduled Commercial
Banks are required to maintain with RBI an average cash balance, the
amount of which shall not be less than three per cent of the total of the
Net Demand and Time Liabilities (NDTL) in India, on a fortnightly
basis and RBI is empowered to increase the said rate of CRR to such
higher rate not exceeding twenty percent of the Net Demand and Time
Liabilities (NDTL) under the RBI Act, 1934.
So, now due to the increase in these rates the Scheduled Commercial Banks will
face the problem of shortage and increase in the cost of funds due to which either it
will have to increase its advances rate or decrease its deposit rates.
Facing such a dual dilemma and in addition the competition between banks makes it
even tougher to take a decision on either side.
So is the subject of INTEREST RATE VOLATILITY RISK getting more and more
encouragement and so is this study made.
GAP analysis
Interest rate risk measurement can be done by inspecting assets and liabilities
classified into maturity buckets, and computing the ‘gap’ between assets and
liabilities, in each time bucket. A bank can compute the gap statement where each
component is classified into a time bucket based on time to repricing.
In India, this ‘interest rate risk statement’ is computed by banks and submitted to the
regulator, the Reserve Bank of India. The statement is, however, not required to be
made public. Public disclosure consists of what is called ‘the liquidity statement,’
which shows the maturity distribution where each component is classified based on
the time to maturity. If gap analysis had to be undertaken by independent analysts,
then this would require imputation of the interest rate risk statement using public
disclosures.
104
While gap analysis reveals mismatches at various maturities, it does not offer a
mechanism for reducing them into a single scalar measure of the vulnerability of the
bank, and in judging the economic significance of the vulnerability.
Rate Sensitive Assets (RSA) includes:
Short term securities issued by the government and private borrowers
Short term loans made by bank to borrowing customers
Variable rate loans made by the bank to borrowing customers
Rate Sensitive Liabilities (RSL) includes:
Borrowings from money market
Short term savings A/c
Money market deposits
Variable rate deposits
UBI
1 - 14
days
15 -
28
days
29
days –
3
months
3
months
– 6
months
6
months
– 12
months
1 yr –
3 yrs.
3 yrs.
– 5
yrs.
Over 5
yrs.
Deposits 6123 1025 8183 9436 13653 21194 5987 38256
Loans &
Advances
3932 2018 7960 7080 9483 29515 7278 7133
Investment,
securities
354 329 1058 697 1163 9827 5120 15266
Borrowings 1568 28 387 397 759 1558 50 13
105
1 - 14
days
15 - 28
days
29
days –
3
months
3
months
– 6
months
6
months
– 12
months
1 yr –
3 yrs.
3 yrs. –
5 yrs.
Over 5
yrs.
RSA 4286 2347 9018 7777 10646 39342 12398 22399
RSL 7691 1053 8570 9833 14412 22752 6037 38269
GAP -3405 1294 448 -2056 -3766 16590 6361 -15870
Observations
More amounts of borrowings are usually made in the short term maturity
buckets than in above 1 year maturity buckets.
Huge investments are made in the maturity bucket of over 5 years.
The amount of deposits is highest in the maturity buckets of 1 – 3 years and
above 5 years buckets.
The amount of loans and advances is also more in the maturity bucket of 1
year – 3 years.
Generalizations
When the GAP position is positive and when interest rates rise, there will be
increase in the Net Interest Income.
When the GAP position is positive and interest rates fall, there will be
decrease in Net Interest Income.
When GAP position is negative and when interest rates rise, there will be
decrease in Net Interest Income.
When GAP position is negative and when interest rates fall, there will be
increase in Net Interest Income.
106
Suggestions
The interest rate risk measurement system employed by a bank should be
sufficient to access the effect of interest rate changes on both earnings and
economic value.
The system should also provide a meaningful measure of the Bank’s interest
rate exposure and should be capable of identifying any excessive exposures
that may arise.
Outcome
To conclude, a positive GAP is beneficial when interest rates rise, as it will result in
increase in Net Interest Income. A negative GAP will prove to be advantageous when
interest rates fall, as it will also result in increase in Net Interest Income. Total
elimination of interest rate risk may not be practical in Indian Banking scenario.
However, being conscious of its existence, magnitude and impact and managing it
well is the essence of risk management function.
107
Value Added Notes
A Comparison of Domestic Deposit Card Rates of different Indian Banks
Lower than UBI rate Higher than UBI rate Equals UBI rate
Tenor BOI OBC
~SBI @
PNB Central Canar
aBOB IOB $
Allahabad ^^
Min MaxUnion Bank
12/11/07
01/01/08
04/01/08
29/10/07 03/12/0710/08/07
15/11/07
01/11/0710/02/0
824/10/0
7
Max Limit < 5Cr - <1 Cr < 5Cr -Upto 2
Crs<1 Cr - - -
7-14 days 3.00 3.50 - 4.25 3.75 4.00 3.50 3.50 3.00 3.00 4.25 3.75
15-30 days 4.50 3.50 4.75 5.25 4.75 4.75 4.50 4.00 3.00 3.00 5.25 4.00
31-45 days 4.50 4.75 4.75 5.25 4.75 4.75 4.50 4.75 4.75 4.50 5.25 4.00
46-90 days 5.50 5.50 5.25 6.25 5.50 5.50 5.00 5.25 6.50 5.00 6.50 5.00
91-129 days
6.00 6.50 7.00 6.25 6.00 6.00 6.25 6.00 7.00 6.00 7.00 5.50
120 Days 6.00 8.00 7.00 6.25 6.00 6.00 6.25 6.00 7.00 6.00 8.00 5.50
121 - 179 days
6.00 6.50 7.00 6.25 6.00 6.00 6.25 6.00 7.00 6.00 7.00 5.50
180 days -270 days
7.25 7.75 7.50 7.50 7.25 7.25 7.25 6.75 ++ 7.50 7.25 7.75 6.50
271 days to <1 year
7.25 7.75 7.50 7.50 7.25 7.25 7.25 7.50 ^^ 7.50 7.25 7.75 6.50
1 year 8.50 8.75 8.75 8.50 8.25 8.50 8.50 8.25 8.50 8.25 8.75 8.25
> 1 years 554 days
8.50 8.75 8.75 8.50 8.25 8.50 8.50 8.25 8.50 8.25 8.75 8.25
555 Days 8.50 8.75 8.75 8.50 9.25 8.50 8.50 8.25 9.00 8.25 9.25 8.25
556 Days < 2 years
8.50 8.75 8.75 8.50 8.25 8.50 8.50 8.25 9.00 8.25 9.00 8.25
2 years < 3 years
8.75 9.00 8.50 8.50 8.50 8.75 8.25 8.50 8.75 8.25 9.00 8.75
3 years 8.75 9.00 8.50 8.50 8.75 8.75 8.25 8.75 8.75 8.25 9.00 8.75
> 3 years < 5 years
8.75 8.75 8.50 8.50 8.75 8.75 8.25 8.75 8.75 8.25 8.75 8.75
5 years < 7 years
9.00 8.75 8.50 8.50 8.50 8.50 7.50 8.50 8.75 7.50 9.00 8.75
7 years < 8 years
9.00 8.75 8.50 8.50 8.50 8.50 7.50 8.50 8.75 7.50 9.00 8.75
8 years and above
9.00 8.75 8.50 8.50 8.50 8.50 8.00 8.50 8.75 8.00 9.00 8.75
@ 91-180 days -7% and 181 <1 Yr -7.50%
** Union 94 Months Scheme - 9% $ IOB - For deposit above 25 lakhs
108
Chapter 9
Indianising Altman’s Z score Model
20695 is the number of cases of businesses defaulting an amount of more than 100
lacs individually in the year 2007 which is an increase of nearly 17.5% over and
above its previous year.
It can be said that greatest of the risk that the bank faces is the credit risk. If the
Bank knew that a bankruptcy might occur in the next year or two, it could better
protect itself. But how can one predict which businesses are likely to go bankrupt and
which are not?
About 40 years ago, Edward I. Altman set out to answer this question. Altman, a
financial economist at New York University's Graduate School of Business,
developed a model for predicting the likelihood that a firm would go bankrupt. This
model uses five financial ratios that combine in a specific way to produce a single
number. This number, called the Z Score, is a general measure of corporate financial
health.
Later, Altman developed a modified version for private manufacturing firms and a
second version for use by all businesses.
But the study undertaken will consider only its main model i.e. mainly the public listed
companies.
Before going on with Indianising Altman Z score model let’s first understand the
General Altman Z score model theoretically.
“Well, when you're trying to create things that are new, you have to be prepared to be on the edge of risk.” - Michael Eisner
109
A Short Z-Score History
In 1966 Altman selected a sample of 66 corporations, 33 of which had filed for
bankruptcy in the past 20 years, and 33 of which were randomly selected from those
that had not. The asset size of all corporations ranged from $1 million to $26
million...approximately $5 million to $130 million in 2005 dollars.
Altman calculated 22 common financial ratios for all 66 corporations. (For the
bankrupt firms, he used the financial statements issued one year prior to bankruptcy.)
His goal was to choose a small number of those ratios that could best distinguish
between a bankrupt firm and a healthy one.
To make his selection Altman used the statistical technique of multiple discriminant
analysis. This approach shows which characteristics in which proportions can best
be used for determining to which of several categories a subject belongs: bankrupt
versus nonbankrupt, rich versus poor, young versus old, and so on.
The advantage to MDA is that many characteristics can be combined into a single
score. A low score implies membership in one group, a high score implies
membership in the other group, and a middling score causes uncertainty as to which
group the subject belongs.
Finally, to test the model, Altman calculated the Z Scores for new groups of bankrupt
and nonbankrupt firms. For the nonbankrupt firms, however, he chose corporations
that had reported deficits during earlier years. His goal was to discover how well the
Z score model could distinguish between sick firms and the terminally ill.
Altman found that about 95% of the bankrupt firms were correctly classified as
bankrupt. And roughly 80% of the sick, nonbankrupt firms were correctly classified as
nonbankrupt. Of the misclassified nonbankrupt firms, the scores of nearly three
fourths of these fell into the gray area.
110
The Z score Ingredients
The Z score is calculated by multiplying each of several financial ratios by an
appropriate coefficient and then summing the results. The ratios rely on these
financial measures:
Working Capital is equal to Current Assets minus Current Liabilities.
Total Assets is the total of the Assets section of the Balance Sheet.
Retained Earnings is found in the Equity section of the Balance Sheet.
EBIT (Earnings Before Interest and Taxes) includes the income or loss
from operations and from any unusual or extraordinary items but not the tax
effects of these items. It can be calculated as follows: Find Net Income; add
back any income tax expenses and subtract any income tax benefits; then
add back any interest expenses.
Market Value of Equity is the total value of all shares of common and
preferred stock. The dates these values are chosen need not correspond
exactly with the dates of the financial statements to which the market value is
compared.
Net Worth is also known as Shareholders' Equity or, simply, Equity. It is
equal to Total Assets minus Total Liabilities.
Book Value of Total Liabilities is the sum of all current and long-term
liabilities from the Balance Sheet.
Sales include other income normally categorized as revenues in the firm's
Income Statement.
111
The original model took the following form:
Z = 0.012 X1 + 0.014 X2 + 0.033 X3 + 0.006 X4 + 0.999 X5 (1)
Where,
X1 = Working Capital/total assets
X2 = Retained Earnings/total assets
X3 = EBIT/total assets
X4 = Market value of equity/book value of total liabilities
X5 = Sales/total assets
In the original version, all ratios were stated as percentages, except X5, which was
stated as an absolute value. For example, if EBIT/total assets ratio were 15%, or
0.15, X3 would be assumed to equal 15. Eventually, a more convenient specification
was proposed:
Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 1.0 X5 (2)
In this specification, an EBIT/total assets ratio of 15% would result in X3 = 0.15. X5,
as was the case in the original version, is stated as an absolute value. Altman himself
used this version in Altman and Lafleur (1981).
For public manufacturer if the score is 3.0 or above – bankruptcy is not likely. If the
score is 1.8 or less – bankruptcy is likely. A score between 1.8 and 3.0 is the gray
area.
112
Z score GroupsLess than 1.81 Default groupBetween 1.81 and 3.00 Gray zoneMore than 3.00 Non default group
Objective of the study
The objective behind this study is to find out whether Altman Z score model can be
implemented in India; whether it can predict before a year or two that this public
listed company is going to default or not and if not why i.e. what are its criticisms
and what steps should have to be taken to make it fit for public listed companies of
India.
As our purpose of the study is to find out that it can predict default or not we will be
considering only the default companies.
Study method
In this study we will be considering 30 public listed companies of India which have
already defaulted for amount of more than 100 lacs as on 31st march, 2008.
So, now as we know these 30 companies have already defaulted in the year 2008,
we will be using these companies balance sheet and profit and loss data for the
years older than 2007.
So if it can predict accurately with a good success rate in that respective year that the
company is going to default with the bank than it will prove that Altman Z score
can be indianised.
113
Source
The data of defaulted companies have been taken from www.cibil.com. The banks
with whom the businesses have defaulted are as follows:
Financial Institutions Global Trade Finance Ltd.
Foreign bank JP Morgan Chase NA
Nationalized Banks Andhra Bank, Central Bank of India
Others SBI Orissa, EXIM Bank of India, SIDBI
Analysis of the study
Z Score of the 30 default companies considered are as follows:
i. Z = 1.5421
ii. Z = -2.9567
iii. Z = -1.1275
iv. Z = -26.6512
v. Z = 2.6882
vi. Z = 4.0515
vii. Z = -0.728
viii. Z = -12.7313
ix. Z = -2.8853
x. Z = 4.1753
xi. Z = -1.7516
xii. Z = - 64.3325
xiii. Z = -16.8121
xiv. Z = -6.3888
xv. Z = 0.1384
xvi. Z = 0.4046
xvii. Z = -8.6366
xviii. Z = 2.4323
114
xix. Z = 5.1028
xx. Z = 0.7418
xxi. Z = -2.5588
xxii. Z = 1.3643
xxiii. Z = -70.9386
xxiv. Z = 4.6558
xxv. Z = 5.1679
xxvi. Z = -102.6486
xxvii. Z = -3.7374
xxviii. Z = -71.1534
xxix. Z = -69.753
xxx. Z = -6.5002
Default group 23
Gray zone 2
Non default group 5
If we consider default groups to total number of companies it gives us 76.67%
success rate and if we consider both default group and gray zone to total no. of
companies it comes to 83.33% success rate.
Findings
Altman Z score model can be Indianised for public sector companies as it has the
capability to predict whether the company will default or not before a year or two.
Problem faced
Some companies taken above include balance sheet and Profit and loss data of even
as old as years such as 2000, 2001 and 2002.
So if the data was available for the past 1 year or 2 it may have given us a better
success rate than it has given us above.
115
Before concluding I would like to throw light on some criticisms of the Altman’s Z score model:-
Market value of Equity (MVE) = no. of shares * share price/CL + LT liability
As share prices change every day, MVE changes every day and as a result
the Z score too.
Hence proving to be very hectic for banks as a sudden volatility like going on
now in the Indian Stock Markets can change Z score of businesses from very
high to a low point or vice versa.
If Company is in gray zone it is not clear in which direction the company is
and where it will go?
Qualitative factors such as Management team, innovative tools used,
products, segments, marketing initiatives, future growth plans, SWOT
analysis, industry in which business operates, competition, raw material
availability and supply, demand of the products, labor union stability, etc are
ignored. Stress is given only on the financial ratios.
If share prices are not available e.g. shares are not traded for last 2-3 months
or a year what value to be taken?
Quarterly results of Profit & loss is available but of balance sheet it is not. So
it is difficult to find quarterly Z scores.
Private sector companies data not easily available and if available question
on its authenticity arrives.
116
Outcome
To conclude it can be said that Altman’s Z score model can not only be used by
banks but also the investors because many of the above companies were not traded
after they defaulted.
But it still can’t be used as a single credit tool by banks to check the credibility of the
businesses. So it may be preferable to include Altman’s Z score model in the credit
rating model of the bank in place of the financial ratios used by the banks.
117
Conclusion
Future remains uncertain. It has become more
difficult now to predict what is going to happen and
what is in store for an economy in the near future.
The global factor which didn’t affect much the
economy earlier is now affecting it very badly. The
factor to which I am pointing out is Crude oil which
touched a record high of $147/barrel nearly an
increase of 45% from the beginning of the year
2008.
It is because of this reason that inflation peaked to
a 13 year high of 12.01% for the week ended 26th
july, 2008. BSE Sensex of 30 companies has
weightage of around 20% for oil companies which
fell due to surging oil prices making sensex also to
dip.
Due to rising inflation, RBI which has the
responsibility to curb it took steps by using its tools
in the benefit of the economy. It raised the Repo rate to 9% (125bps increase) and
the CRR to 9% (100bps increase). Due to this step Indian banks felt the pinch as the
cost of funds increased. Due to which banks started to raise rates as you can
observe in the table.
Another risk that the Indian Banks are now facing is the exchange rate volatility (table
below) due to which hedging risk using various Derivative tools has become one of
its important function which cannot be ignored.
THE RISING COST OF MONEY(Major banks’ lending rates)
Bank Increase(bps)
New rate (%)
ICICI Bank
Consumer loans* 75 14.25
Companies** 75 17.25
HDFC
Floating rate 75 11.75***
Fixed rate NIL 14.00
PLR INCREASES
Central Bank 75 13.75
IndusInd Bank 75 17.00
Yes Bank 50 17.00
Bank of Rajasthan 100 16.00
DEPOSIT RATES
Bank Increase (bps)
ICICI Bank 75-100
Yes Bank 25^ * Floating reference rate; ** Benchmark advance rate *** Minimum rate on new loans ^ For deposits of one year and one day to 18 months (Source: Banks)
118
The above table gives us the exchange rate of just 4 days that how volatile the Forex
market has been these days.
Also it can be observed that when exchange rate was out of control of RBI i.e. it was
appreciating, inflation was under control at around 5%. But when exchange rate
came under control of RBI inflation got out of control.
Both situation are not at all favorable for Indian Banks due to which it has become
very important to have an active Risk Management department and an Asset Liability
Management Department in a Bank.
Another issue which needs to be seen is the credit rating model used by the banks. It
is very difficult to quantify credit risk but as the rates tends to rise this factor gets
more important from bank’s point of view. An effort is made in this project to use
ALTMAN’s Z score model for Indian Public listed companies which can prove very
effective at times as it will give an indication that the client may default in the near
future making the bank more vigilant and help in taking steps for the same well in
advance.
Currency 04/08/08 05/08/08 06/08/08 07/08/08
GBP 84.6335 82.4265 81.929 81.755
Euro 66.911 65.2860 64.75 64.665
USD 42.545 42.245 42.085 42.075
Aus $ 40.711 38.6765 38.2195 38.187
119
REFERENCES
Books
Credit Derivatives (George Chacko, Anders Sjoman, Hideto Motohashi,
Vincent Dessain)
Total Quality Loan Management (S Wayne Linder)
Treasury, Investment & Risk Management (The Indian Institute Of Bankers)
Derivatives Simplified (Mahapatra, Bhaskar)
International Trade & Finance (ICFAI Publications)
Risk Management in Banking (Joel Bessis)
Export Import and Logistics Management (Usha Kiran Rai)
A Foreign Exchange Primer (Shani Shamah)
International Finance (B.M.S. Semester – VI, Dipak Abhyankar)
Economics of Global Trade & Finance (M. Com Part – I)
Magazine
Banking Finance Volume XXI No. 5 May ‘08
Websites
www.rbi.org.in
www.dgft.delhi.nic.in
personal website of R Kannan
www.bis.org
www.defaultrisk.com
www.unionbankofindia.co.in
www.infodriveindia.com
www.i-b-t.net
120
www.ssrn.com
www.eximin.net
www.finmin.nic.in
www.business-standard.com
www.bloomberg.com
www.livecharts.co.uk
www.advfn.com
www.mospi.nic.in
Indiabudget.nic.in
Exim.indiamart.com
www.oil-price.net
UBI Database:
Handbook of Imports
Handbook of Exports
Annual Report of UBI
Credit Rating Model
Private Companies financial results
UBI website
