Shadow Banking

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Credit worthiness of a prospective borrower can be determined by 5 C’s or PARSER approach. Combination name of 5Cs is which Capacity, Character, Collateral, Capital and Conditions. Capacity refers to both legal capacity; whereby whether an applicant have the ability to commit an organization to the loan contract, and economic capacity; if the loan applicants have the ability to meet the required schedule repayments. Character refers to the personal factor of borrower’s likelihood of repaying the loan. Collateral is to show the bank if the borrower have the quality to borrow.

The PARSER, Personal element, Amount Required, Repayment, Security, Expedience and Remuneration. Personal element relates to the board and senior management’s ability and ethics, and the firm’s corporate culture and track record. Amount required, is the amount requested as per what is needed or is there an unexplainable amount. At times, company might borrow to repay another debtor, such loan are deem not healthy for bank, as they do not make any returns from it. Repayment, whether is the loan being smoothly repaid according to its terms. Security controls moral hazard and it acts as a secondary source of recovery should the loan be defaulted. Expedience simply question if the loan fit the lender’s business objective. As for a bank, loan made out must be profitable and recoverable. There is absolutely no point if a loan were to make high potential return but the chance of borrower making repayment is low. Lastly, remuneration can also be used.

Restructuring prospects.

According to a working paper by International Monetary Fund, (Peter Nyberg, 1997). It is essential for the bank to do a exhaustive audit to determine exactly the legal liabilities and assets of bank. Taking into account valuation of assets, including: a valuation of collateral for loans (involving the valuation of individual pieces of or right to real estate, guarantees and undertakings by third parties, as well as

securities); an evaluation of debtors’ ability to repay problem loans (involving an evaluation of enterprises’ future economic prospects as well as of the bank’s legal and real ability to ensure an improvement in them); and an evaluation of stock holdings (involving an evaluation of how the value of such stock should be maximized, by immediate sale, by restructuring the enterprise, or by writing off the stock).

Operational restructuring decisions may call for skills that are not necessarily found together in any of the existing authorities (for instance, auditing, financial engineering, business plan evaluation, credit risk evaluation). It is vital to possess substantial autonomy to avoid a conflict of interest. Use of public funds will be monitored and the funds’ allocation done in its normal manner which requires clearing and adequate documentation as a precondition for their release. The central banks are to steer clear of providing preferential funding, but could, if prudential conditions are met, provide short-term liquidity support.

Bank’s lending policies depends heavily on whether if it’s retail or corporate loans. Retail loans usually have small loan size but large volume of applicants. Thus the emphasis will be on empirical analysis. While for corporate loans, judgmental and empirical evaluations methods will be utilize. The corporate loans generally have large loan size but smaller number of applicants. The attention will be on judgmental method that the loan officer will assess the credit worthiness of the corporate borrower. The higher credit risk of the borrower, the higher the loan rate.

Since the retail loan are small in size and the cost of collecting information on household borrowers is high, it is most probable that the retail borrowers are charged at the same rate of interest that implies the same level of risk. Credit rationing involves restricting the amount of loans that are available to individual borrowers. Credit risk can also be controlled by using credit quantity and interest rates. A higher risk premium is charged on a more risky borrower to control credit risk. The rationing credit through quantity limits will occurs at some interest rate level even though positive loan demand exists at even higher risk premiums. Therefore, credit rationing is done by reducing the loan amount or rejecting the loan applications.

A company should be doing their best in order to give a positive sign of their future. The fundamental and the health of the company is what the lenders are concerned about. Free cash flow must be positive and increasing. Account receivables should also be under control. All these should be done well enough in order to borrow money from the lenders and to get the lowest interest rate as the risk of default becomes lower. Lenders have no right to control over your company just because you borrow money from them; all they want to know is that you are meeting your loan repayment obligation or covenant. The repayment sources and conduct cash flow analysis can use debt-to-income ratio. Different industries have different debt-to-equity ratio, they are not able to be compared by different industries. They should be compared to the other companies in same industries within the same time frame.

Since the 2008 financial crisis happened, new regulations are enforced and stricter in lending loans to prevent borrowers defaulting. Companies which have strong fundamental might also end up defaulting in the event when announced bankruptcy. Therefore using both judgemental and empirical credit analysis are important to consider ability to predict creditworthiness of the applicant. Combinations of these two are used at this point of time. If the application is denied it simply means that the applicants did not earn a high enough score to meet the minimum credit ability or capability to keep up with the loan.

SUMMARY

In conclusion, only when the company meet up with the industry average, cash flow can be generated. It is important to do aging for inventory. Credit worthiness is important in terms of banks’ lending and restructuring prospects. It also allows banks to estimate the risk of profit or loss from a borrower. The best way to determine the credit worthiness of the borrower is by 5Cs. After viewing the borrower profile, separate the bad borrower and the good borrower a side, bad borrower will denied credit and good borrower will granted credit, but not all bad and good borrower granted and denied credit because it was conduct by the cut off score. For high risk borrower, loan rate will be higher. Using loan to value ratio is important for financial institution so that the lender can protect their money, which they