Kashish Khattar is a 4th-year student at Amity Law School, Delhi. He writes on topics related to investment, banking and arbitration law. The following is a list of terms that are typically used in the banking sector of the country.
Let us cut right to the chase and talk about the top 20 terms you should know about if you are working in the banking sector of the country:
The prompt corrective action (“PCA”) framework is simply a corrective measure plan which is used to intervene early so as to restore the financial health of banks that are at risk by limiting their capital levels. PCA mainly puts up lending restrictions on the banks and doesn’t let them do business as usual. PCA kicks in when banks fall short on any of the three parameters – capital to risk-weighted ratio; non-performing assets; and return on assets.
Strategic Debt Restructuring
SDR was introduced in 2015 to let banks recover their loans from ailing companies. It lets the Joint Lenders Forum (“JLF”) or simply known as the consortium of lenders to convert their debt into equity. The lenders simply become owners of the company they had lent money to. The scheme basically lets the banks take control of the distressed companies. The JLF can control this entity for 18 months after which they have to sell it to a new set of promoters.
This is a kind of turnaround opportunity given to the banks by making the distressed company an attractive target and selling it to a new set of promoters. This is what was proposed to happen at jet airways by its lenders.
NPA – Non Performing Assets
Simply put, a loan given by a bank can be seen as an asset. Further, when the principal or the interest are not being given to the bank, they are not performing. They become a non-performing asset for the lender aka the bank. Typically, an asset which stops giving interest to its investors for more than 90 days is known as a non-performing asset. The 90 days period is kind of a thumb rule being followed by a lot of countries and can vary on case to case basis.
ROA – Return on Assets
It is basically a performance indicator of banks. RoA is profitability ratio and shows how profitable a bank is in relation to its total assets. Typically, it tries to measure the efficiency of utilizing the bank assets to generate profit for themselves and is calculated out by dividing net income by average total assets. A higher RoA indicates a better managed and more efficient bank.
RoA = net income/avg total assets.
Mezzanine financing is a hybrid of debt and equity financing that gives the lender the right to convert to an equity interest in case of a default. It is paid after the senior lenders such as venture capital companies, private equity companies and others are paid.
It is usually listed as an asset on the company’s balance sheet. It is quickly available to the borrower without any collateral. A convenient loan without collateral only means one thing, a higher rate of interest. The rate of interest in relation to mezzanine financing can range anywhere from 12% – 20%. Typically, in India, it can range from 13-14%.
External commercial borrowings or ECBs can be simply understood as loans from foreign institutions. ECB is typically seen as a way of growth capital for most of the corporate sector in the industry. It is of strategic importance in certain sectors which include power, aviation and infrastructure. It is of so much importance the Indian businesses that an entire team of law firm exclusively handles ECBs. It can be thought of as the cheapest source of capital in India.
Loans have to be taken from a foreign branch, such as Standard Chartered Bank London, HSBC Hong Kong or a foreign financial institution such as the Asian Development Bank. However, a loan from HSBC Delhi or Standard Chartered Bombay won’t qualify as a foreign loan. The simple reason being the loan would be provided in Rupees. ECB is a loan taken in foreign currency. ECB can include preference shares, convertible & non-convertible debentures and bonds which are issued to foreigners apart from a simple loan. A loan which is taken from a foreign shareholder who owns at least 25% of the shares of the borrower company is also included in the ambit of ECBs.
A bridge loan is simply there to fill the gap between short term cash requirements and long term loans. They are typically taken for a period of not more than 12 months. As you may have guessed, the rate of interest is huge and these kinds of monies would require a piece in the pie. I mean that some equity or debentures is necessary to back the lender for this kind of a loan.
Simply put, bridge loans are short-term loans which are granted typically to industrial undertakings so that they can meet their urgent and essential needs during the period. These periods are seen when some kind of formalities for long term loans is being sanctioned by financial institutions. Further, this kind of period also maybe when the company decides to raise the funds from the capital markets.
Fun fact: These loans are granted by banks or by financial institutions themselves and are automatically repaid out of an amount of the term loan or the funds raised in the capital market.
The key guidelines to sanction bridge loans as notified by RBI should include the following aspects:
- Security should be for the loan;
- There should be compliance with the individual or group exposure norms;
- The value of the outstanding bridge loan (or the limit sanctioned, whichever is higher) during the year;
- Ensuring the end use of bridge loan, as to where is the loan going to be used; and
- The maximum period of the bridge loan to be one year only.
Revolving credit is defined as a line of credit where the borrower has to pay a commitment fee to a financial institution such as a bank to borrow money and is then allowed to use the funds whenever they are needed. They are typically used for operating some big projects or purposes. The amount can vary from on a month to month basis. Revolving credit is usually taken out by corporations or high net worth individuals. The maximum amount of revolving credit is called the credit limit. The bank which is the main financial institution in these kinds of transactions has to reach an agreement over the commitment fee, interest expenses and carry forward charges for consumer accounts.
Revolving credit is an added incentive for people or companies that face sharp fluctuations in cash flow and face unexpected expenses. The convenience and the flexibility account for the high rate of interest which is charged by the banks. They are different than instalment loans as they require a fixed number of payments over a period of time whereas the revolving credit only requires payment of the applicable interest and the fee.
They are basically the conditions put on by the lenders on the actions of the borrower. These covenants are incorporated into the lending agreements. Simply put, the debt covenants in the loan agreement tells the borrower what it can and cannot do. They are also known as banking or financial covenants.
They are of two types: positive; and negative covenants. Positive ones typically what the borrower has to do. Such as achieving certain thresholds in certain ratios, performing regular maintenance of capital assets etc. Negative covenants are the ones which the borrower doesn’t have to do. They include instances like selling certain assets, borrowing more debt and enter into a certain type of agreements.
Simply put, when a company borrows money that is to be paid at a future date is known as debt financing. It can take the shape of a secured or an unsecured loan. Typically, this kind of loan is taken for an acquisition or finance some working capital for a project. Debt funding is only taking a principal amount and paying interest on it.
You are not losing out on any equity of your company while you’re at it. It is a time-bound activity with predefined instalments to be paid at the agreed period. The loan is usually collateralised with some assets of the company. The secured or unsecured loan also helps determine the kind of line of credit that you’re going to get. Debt funding is said to be a new thing for India Inc. The venture debt space has been buzzing with a lot of activity in the startup space.
A corporate guarantee is a guarantee in which a corporate agrees to be responsible for the financial, contractual obligations of the principal debtor to the creditor. These are invoked when the principal debtor fails to perform their financial or contractual obligations. A typical corporate guarantee is unsecured by nature. Further, it is imperative to check the charter documents of the company to ensure that they are ensured to issue a corporate guarantee and verify the prescribed limit. Furthermore, it is quite important that resolutions wrt these guarantees are passed for this purpose by the company accordingly.
Letter of Credit (“LOC”)
A letter of credit is basically a letter that assures that the seller that the buyer is good for his money. Banks typically require a pledge of securities or cash as collateral for the issuance of a letter of credit.
A letter of credit (“LC”) is issued by the bank at the request of its customer (Importer) in favour of the beneficiary (Exporter). It is an undertaking by the bank, informing the beneficiary that the documents under the LC will be honoured if the beneficiary submits all the paperwork as per the terms and conditions. Banks are mainly involved in LC to avoid default in payments, to facilitate trade and also enable the exporter and importer to receive and pay for the goods sold and bought.
Shadow banking is a name given to all the intermediaries that provide services similar to a traditional bank. They typically carry out banking function but do not come into the ambit of the banking regulation of a country. Shadow banking got popular in the financial crisis of 2008 and was deemed to be one of the main factors the said crisis. It was coined by Paul Mcculley in 2007 to mainly define the American non-banking intermediaries who used short term deposits to finance long term loans. These banks are defined as ‘credit intermediation involving entities and activities remains outside the regular banking system’. NBFCs in the country come under the purview of the shadow banking sector. However, they are highly regulated by our central bank. Shadow banking has been the talk of the town after the recent crisis regarding the IL&FS default.
It can be simply understood as a loan for a specific amount which has a specific repayment schedule and a fixed or floating interest rate over it. Meaning, it can be paid in a lump sum or in suitable amount according to the agreement. A loan is known as a demand loan if it has to be repaid within three years. If the loan’s tenure is three or more then it is known as a term loan.
They are mainly given to the manufacturing, trading and service sectors which require funds for buying various fixed assets, such as land, building, machinery, and electrical installation etc. Repayment of term loans depends mainly on the firm’s capacity to produce goods or services by the fixed assets financed by the bank.
. Cash credit
Can be seen as the main method of how banks lend in the country. Accounts for around 2/3rd of the credit of the total credit offered by banks. The banker specifies a limit, known as the cash credit limit. It is a flexible system of lending under which the borrower has the option of borrowing funds whenever he needs.
The bank specifies that limit. This kind of credit is typically sanctioned for a year and is secured by the security of some tangible assets or personal guarantees. If the arrangement is working satisfactorily, the limit can also be renewed. Talking about interest, it is calculated and then charged on the customer’s account.
A green bank is a financial institution that has the aim of reducing the carbon footprint and promote environmentally friendly activities. It can come in a lot of forms like using online banking instead of branch banking. This kind of bank is also called an ethical bank or a sustainable bank. They are controlled by the same authority as a normal bank but with an added agenda of protecting the environment.
In a consortium lending, two or more lenders join hands to finance a borrower. The lenders, ie, the banks join hands through an inter-se agreement to fulfil the credit needs of the borrower. This kind of arrangement is typically done through common documentation. The lenders also let one of the banks be the consortium lead. This leader is held responsible for all the documentation that is executed by the borrowers on behalf of the whole consortium. This kind of lending gives banks the leeway to make their own guidelines to ensure the safety of their credit. This kind of system also ensures that the risk is shared amongst the lenders.
A pari passu charge is created on the securities that are offered by the borrower against the total credit offered by the consortium. The pari passu charge basically means that if the borrower has to go into liquidation or the securities are in any way, disposed off by the consortium. The securities on which the charge is created will be distributed in proportion to the creditor’s contribution in the consortium.
Syndicate loan is said to be slightly different than consortium lending in terms of operations, procedures and the legal relationships involved in the transaction. In syndicate loan, a group of lenders come together to provide credit to a borrower. The borrower can be a corporation, government or any entity involved in a large project. All the lenders share risk in this kind of a transaction and needless to say, all the lenders in the syndicate contribute towards the loan amount.
One of the lenders acts as the arranging bank who mainly works out the loan on behalf of all the other lenders in the syndicate.
A loan syndicate happens when a single borrower needs a really big loan that a single lender fails to provide. This also happens when the lender cannot expose itself to the risk that gets generated if he decides to lend such a huge amount. The lenders then form a syndicate that helps them reduce the risk and share the financial opportunity with all the lenders involved. The liability of every lender is based on the kind of contribution they make towards the total loan. A single agreement typically contains all the terms and conditions of such an arrangement.
Letter of commitment
A letter of commitment is a formal binding arrangement between the lender and the borrower. It outlines the kind of commitments that have to be fulfilled when they get into the lending arrangement. The nature of the loan, the amount that has to be borrowed, the repayment period, interest rate are some of the things that are there in this document. The main objective of this commitment letter is to tell the borrower that the lender is ready to give out the loan. However, they need but the borrower will have to fulfil said conditions in order to access the credit that they need.
The basic contents of the commitment letter can be the type of loan applied for; the loan amount; terms agreed upon loan repayment; interest rate; estimated period payments; effective date and commitment fees; and cancellation policy.
Multiple banking arrangements
This kind of arrangement is where the borrower obtains credit independently from other lenders. There is no kind of contract between the lending banks. In multiple banking, each lender performs their own credit assessment and obtains independent documentation for every primary and security charge created over the assets. There is no single kind of document as seen a consortium loan or syndicate finance.
The main difficulties as seen in multiple banking arrangements is that there is no coordination in between banks among appraisal, documentation and other terms in a loan. A borrower gets the freedom to deal with each bank so he can negotiate the terms in a better way. However, this also ruins the tight credit culture that can be maintained through single agreements in consortium loans or syndicate finance.