What is credit appraisal?

A: Hey B! I need some money and I see you have plenty of it sitting idle in your purse. I will return you the whole money with additional interest. Could you lend me Rs 100?

B: Hmm. Let me see.

This happens mostly at one place called Bank. Afterwards what B has to do is to check out for the ‘Credit’ of B. This process of research, exploration in short is called Credit Appraisal.

Think this episode from B (read Bank) point of view. Ultimately Bank wants 2 things from any transaction: (A) Safety of capital and (B) Compensation for opportunity cost of money. B is pointless if A is incomplete.

How to ensure safety of Capital?

Couple of jargons need to be introduced beforehand. First one is KYC-Know Your Customer. How the customer does looks like. If it is a company when it was found? What is its business model? What are the revenue items? Is the revenue predictable with a bit of surety? What kind of plants it owns? What is his track record of earning and repayment history?

Second one is-End use. This is the first common sense question. “Bro, what you will do with Rs 100?”

Will you throw it in the roulette? Go Away. Isn’t it?

Knowing what is the end use of the proceeds from the bank, is the first right of the Bank. If it is related to what he has been doing then knowing that gives a Comfort to Banker? What is “Comfort” BTW? Comfort is the holy grail of lending business. Let us assume A and B were the best buddies, at the risk of sounding corny, I would say like Jai and Viru. Then B would have given A the money No question asked. Because he has good relationship with A and he has a “comfort” in lending to him.

Relationship is the name of the game (pun intended)

Have you ever wondered why the lending banks have concentrated portfolio (exposure) towards few big business houses which are the reason Banks are facing asset quality issues? Two reasons: First one is what I would call it: Heuristic. Heuristics is mental shortcut. When you brain have plethora of information to process then brain does not process the whole information. It rather looks out for shortcuts. So, if a Banker is flooded with couple of complex thermal power projects then he discovers a heuristic of going with big names, which sounds trustworthy.

Second is wrong incentive system. Every bank has one role called relationship manager. He handles relationship with corporates. He is incentivised to do more business with each of them. He is not incentivised (at least monetarily) to discourage less credible corporates to borrow from banks. He always plays Good Cop. So the Bank ends up lending to few corporates and the Relationship continues.

So what is correct way of credit appraisal?

If you are a project finance professional or Credit analyst then your job is to ensure that only those proposals get selected which does not have any untied risks in the base case Business plan. Sometimes some sleepwalking dreamy eyed Borrower comes and ask for money based on loosely tied business cases. There could be many risks. But it could be classified in to 2 types: First is factor which can delay the project completion schedule such as: wrong selection of technology, wrong people for assessing and implementation of project, incomplete funds (equity and debt not tied up), incomplete regulatory approvals, land acquisition delays etc. Second is factor which can erode the commercial viability of the Project i.e. the risk of producing something which does not have taker at right price, such as Offtake agreement not signing, Supplier risk, demand supply mismanagement, competition risk, operation and maintenance mismanagement, natural calamity etc.

Further, you prepare a financial model and run sensitivities for all the risk, such as what if project gets delay by 1 year, what if sales price of finished good becomes cheaper by 20%.The ultimate output of this part of exercise is to get a good debt service coverage ratio (DSCR).It will ensure safety of capital at least on paper.

A successful credit appraisal starts with a question and end with an answer. It is about identifying set of applicable risks and grilling the borrower about them, advises them to mitigate those risks with some structuring (that is another chapter in itself) and then presenting to credit committee wearing two hats. This time Good cop and Bad cop both.