LV Thạc sỹ_Improving the quality of credit appraisal for individual customers in VIB

ACKNOWLEDGEMENT
With these very first words of this paper, I would like to express deep
gratitude to my instructor – Ph.D for her dedicated guidance and support from the
initial to the final phase of my thesis.
Additionally, I also sincerely thank Mr.– Director of Vietnam International
Bank – Lieu Giai transaction office and Mr.– Credit officer of Credit management
department for their encouragement and valuable instruction during my internship
at the bank.
Lastly, I expose my regards to other people especially my classmates in
advanced finance class intake 50 for their help in the completion of this thesis.


TABLE OF CONTENTS
ACKNOWLEDGEMENT..........................................................................................i
TABLE OF CONTENTS..........................................................................................ii
ABBREVIATION....................................................................................................vi
LIST OF TABLES...................................................................................................vii
LIST OF FIGURES................................................................................................viii
INTRODUCTION.....................................................................................................1
1.Rationale..............................................................................................1
2.Research questions...............................................................................2
3.Research objectives..............................................................................2
4.Research methodology.........................................................................2
5.Research scope.....................................................................................3
6.Research structure................................................................................3
CHAPTER 1: THEORETICAL FRAMEWORK OF CREDIT APPRAISAL FOR
INDIVIDUAL CUSTOMERS IN COMMERCIAL BANKS....................................4
1.1. Credit for individual customers in commercial banks......................4
1.1.1. Credit activities in commercial banks.......................................4
1.1.1.1. Bank credit definition.........................................................4
1.1.1.2. Classification of bank credit...............................................5

1.1.1.3. Roles of bank credit in the economy..................................6
1.1.1.4. Bank credit risk..................................................................8
1.1.2. Credit for individual customers.................................................9
1.1.2.1. The concept of credit for individual customers..................9
1.1.2.2. Classification of credit for individual customers..............11


1.1.2.3. Roles of credit for individual customers...........................13
1.2. Credit appraisal for individual customers in commercial banks.....14
1.2.1. Concept and characteristics of credit appraisal.......................14
1.2.1.1. Concept of credit appraisal...............................................14
1.2.1.2. General characteristics of credit appraisal........................14
1.2.2. Credit appraisal for individual customers................................17
1.2.2.1. Objectives of credit appraisal for individual customers. . .17
1.2.2.2. Significance of credit appraisal for individual customers.18
1.2.2.3. Process of credit appraisal for individual customers........19
1.3. The quality of credit appraisal for individual customers in
commercial banks............................................................................................21
1.3.1. The concept of appraisal quality for individual customers in
commercial banks............................................................................................22
1.3.2. Indicators reflecting the quality of credit appraisal for
individual customers in commercial banks..................................................22
1.3.2.1. Qualitative indicators.......................................................22
1.3.2.2. Quantitative indicators.....................................................24
1.3.3. Factors affecting the quality of credit appraisal for individual
customers in commercial banks...................................................................27
1.3.3.1. Subjective factors.............................................................27
1.3.3.2. Objective factors..............................................................29
CHAPTER 2: THE REALITY OF CREDIT APPRAISAL ACTIVITY FOR
INDIVIDUAL CUSTOMERS IN VIETNAM INTERNATIONAL BANK – LIEU

GIAI TRANSACTION OFFICE.............................................................................31


2.1. Overview of Vietnam International Bank – Lieu Giai transaction
office................................................................................................................31
2.1.1. Foundation and development history......................................31
2.1.2. Organizational structure..........................................................34
2.1.3. The reality of business activity................................................34
2.1.3.1. Financial result.................................................................34
2.1.3.2. Product and service development.....................................37
2.2. The quality of credit appraisal activity for individual customers in
Vietnam International Bank – Lieu Giai transaction office..............................40
2.2.1. Credit appraisal process for individual customers in VIB Lieu
Giai..............................................................................................................40
2.2.2. Appraisal system for individual credits in VIB Lieu Giai.......42
2.2.3. An example of credit appraisal process for individual
customers in VIB Lieu Giai.........................................................................43
2.2.4. Indicators reflecting the quality of credit appraisal activity for
individual customers in Vietnam International Bank – Lieu Giai transaction
office............................................................................................................49
2.3. Evaluation of credit appraisal activity for individual customers in
Vietnam International Bank – Lieu Giai transaction office..............................54
2.3.1. Achievements..........................................................................54
2.3.2. Drawbacks and reasons...........................................................58
CHAPTER 3: SOLUTIONS TO IMPROVE THE QUALITY OF CREDIT
APPRAISAL

FOR

INDIVIDUAL

CUSTOMERS

IN

VIETNAM

INTERNATIONAL BANK – LIEU GIAI TRANSACTION OFFICE....................61
3.1. The development orientation of credit appraisal for individual
customers in Vietnam International Bank – Lieu Giai transaction office.........61


3.1.1. The business target..................................................................61
3.1.2. The orientations of credit appraisal for individual customers..63
3.2. Solutions to improve the quality of credit appraisal for individual
customers in Vietnam International Bank – Lieu Giai transaction office.........64
3.2.1. Completing the appraisal process, content and method...........64
3.2.2. Modernizing appraisal technology..........................................67
3.2.3. Enriching the quality of human factor.....................................68
3.3 Recommendations...........................................................................70
3.3.1. To the Government..................................................................70
3.3.2. To State Bank of Vietnam.......................................................70
3.3.3. To Vietnam International Bank...............................................71
CONCLUSION.......................................................................................................71
REFERENCES........................................................................................................73
APPENDIX.............................................................................................................74


ABBREVIATION
SBV

State Bank of Vietnam

VIB

Vietnam International Bank

VIB Lieu Giai

Vietnam International Bank – Lieu Giai
transaction office


LIST OF TABLES
Table 2.1: Income status of the client
Table 2.2: Financial status of the client
Table 2.3: Collateral asset information
Table 3.1: Score system in a bank in the U.S


LIST OF FIGURES
Figure 2.1: VIB Lieu Giai’s organizational structure
Figure 2.2: Growth in total assets
Figure 2.3: Growth in profit before tax
Figure 2.4: Growth in capital mobilization
Figure 2.5: Outstanding credit for individuals versus total assets
Figure 2.6: Ratio of outstanding credit for individuals over total assets
Figure 2.7: Overdue debts
Figure 2.8: Ratio of profit from credit over outstanding credit
Figure 2.9: Outstanding credit for individuals

Figure 3.1: Targets for 2012
Figure 3.2: Targets for credit appraisal for individual customers



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INTRODUCTION
1. Rationale
In Vietnamese financial market, commercial banks normally thrive on the
loans and services they provide to businesses. For example, offering funds for new
businesses or expansion of some existing business, managing inter-city or
international transactions involving large sums, or offering financial advice, etc.
However, no bank can completely ignore the individual consumers, as they
constitute a large part of the market and are considered an important source of funds
for the banks.
As the time is passing by, the number of individuals seeking loans from the
banks is increasing day by day. The demands and needs of the consumers are
increasing at a higher rate and so more and more consumers are opting for loans to
satisfy their needs. They seek loans for each and every need and the banks are
advantaging this fact. Doesn’t matter what the requirements are whether they want
to gain loan for a small scale business or want financial aid for houses construction
or even if they want a brand new vehicle, they knock the door of these banks to
solve each and every purpose and hence are falling under debt day by day. These
loans differ in sizes and characteristics, ranging from long term huge mortgage
loans to small loans taken out for shopping through credit cards.
Moreover, loans for individuals are different from business loans in many
ways. Even though the business loans are borrowed by individuals as well, but
people tend to think differently when borrowing for the business as compared to the
borrowing for personal use. Consumer loans are thought to be the more risky ones

than business loans because individuals defaults (fails to payback) more often than
the businesses, that's why consumer loans normally have higher interest rates than
the business loan and also need to be appraised carefully.
In the year 2012, the lending interest rates for individual loans are still high
due to some economic reasons, resulting potentially bigger amount of bad debts for


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commercial banks. Thus the appraisal for individual loans is considered the most
essential phrase that has to be improved and advanced.
Interested in this concern, during more than two months doing internship in
Vietnam International Bank – Lieu Giai transaction office, I have taken my chance
to do research and experience appraisal activities for individuals and finally
conducting this bachelor thesis in finance: “Improving the quality of credit
appraisal for individual customers in Vietnam International Bank – Lieu Giai
transaction office”.

2. Research questions
This thesis intends to achieve answers for these following questions:
- What are bases that credit appraisals for individual customers in
commercial banks are developed from?
- How are appraisal activities for individual credits performed in Vietnam
International Bank – Lieu Giai transaction office?
- What recommendations can be applied to improve the quality of credit
appraisals for individual customers in Vietnam International Bank – Lieu Giai
transaction office particularly and commercial banks generally?

3. Research objectives
This thesis mainly focuses on assessing the status of appraisal activities for

individual credits in Vietnam International Bank – Lieu Giai transaction office
through indicators related to individual credit and real experience during internship
time. From the result of assessment, numerous proposals are raised to improve the
quality of credit appraisals for individual customers in the bank.

4. Research methodology
Method of collecting information and data: reports and data in Vietnam
International Bank – Lieu Giai transaction office, information in newspapers,
internet, reference books, etc.
Method of processing information and data:
- Describing and synthesizing


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- Comparing: trend, proportion, structure
- Analyzing and evaluating (absolute and relative value)
Besides, the research also uses consultancy of VIB Lieu Giai’s credit officers
to have a more realistic look.

5. Research scope
The thesis focuses on appraisal activities for individual credits in Vietnam
International Bank – Lieu Giai transaction office. All data used to analyze the bank
activities in general and the bank’s appraisal activities in particular is extracted from
VIB Lieu Giai’s annual reports for the period 2008 – 2011.

6. Research structure
This thesis research comprises of three main parts:
Chapter 1: Theoretical framework of credit appraisal for individual
customers in commercial banks

This chapter presents an overview on credit activities and appraisal activities
especially for individual credits in commercial banks. The quality of credit appraisal
for individual customers is also discussed with concept, indicators reflecting and
factors affecting it.
Chapter 2: The reality of credit appraisal activity for individual customers in
Vietnam International Bank – Lieu Giai transaction office
This chapter introduces about Vietnam International Bank – Lieu Giai
transaction office with its basic banking activities like capital mobilization, lending
and other products and services. Here, the thesis assesses quality of the bank’s
appraisal activities for individual credits, evaluating its achievements and
drawbacks as well.
Chapter 3: Solutions to improve the quality of credit appraisal for individual
customers in Vietnam International Bank – Lieu Giai transaction office
This last chapter aims at raising recommendations and solutions to enhance
the quality of credit appraisal for individual customers not only in VIB Lieu Giai
but also in Vietnamese commercial banks in general.


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CHAPTER 1: THEORETICAL FRAMEWORK OF CREDIT
APPRAISAL FOR INDIVIDUAL CUSTOMERS IN
COMMERCIAL BANKS
1.1. Credit for individual customers in commercial banks
1.1.1. Credit activities in commercial banks
1.1.1.1. Bank credit definition
a. Credit definition
Credit is the trust which allows one party to provide resources to another
party where that second party does not reimburse the first party immediately but
instead arranges either to repay or return those resources (or other materials of equal

value) at a later date. The resources provided may be financial, or they may consist
of goods or services. Credit encompasses any form of deferred payment. Credit is
extended by a creditor, also known as a lender, to a debtor, also known as a
borrower.
Credit, in commerce and finance, is a term used to denote transactions
involving the transfer of money or other property on promise of repayment, usually
at a fixed future date. The transferor thereby becomes a creditor, and the transfer, a
debtor; hence credit and debt are simply terms describing the same operation
viewed from opposite standpoints.
According to Vietnamese Law on credit institutions:
“Credit extension” means an agreement allowing an organization or
individual to use a sum of money or a commitment allowing the use of a sum of
money on the repayment principle by such professional operations as lending,
discount, financial leasing, factoring, bank guarantee and other credit extension
operations.


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b. Bank credit definition
More specific than definition of credit, bank credit is the borrowing capacity
provided to an individual or a business by the banking system, in the form of credit
or a loan. The total bank credit the individual/business has is the sum of the
borrowing capacity each lender bank provides to the individual/business.

1.1.1.2. Classification of bank credit
Banks and their principal competitors make a wide variety of credits to wide
variety customers for many different purposes. Although there are numerous criteria
to classify bank credit, following are some common categories used by banks in
evaluating and analyzing:

• In terms of maturity:
 Short–term credit: has maturity of less than one year, is often used to
supplement the temporary shortage of working capital of business or
to finance for personal consumption.
 Medium-term credit: has maturity of one-to-five years, is often used
for purposes of fixed assets, purchasing, technical improvement and
innovation, construction and expansion of small, fast capital-recovery
projects.
 Long-term credit: has maturity of more than five years, is often used
to finance the construction of new factories, mortgage projects,
infrastructure developments. Together with medium-credit, long-termcredit forms long term capital and a part of working capital.
• In terms of economic scale of borrowers:
 Credit for corporations and big enterprises
 Credit for small and medium enterprises
 Credit for individuals
• In terms of purpose:
Credit may be divided into some broad categories, declined by their
purposes:
 Real estate loans: are secured by real property – land, buildings, and
other structures – and include short-term loans for construction and


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land development and longer-term loans to finance the purchase of
farmland, homes, and apartments.
 Agricultural loans: are extended to assist in planting and harvesting
crops and supporting the feeding and care of livestock.
 Commercial and industrial loans: are usually granted to businesses to
cover purchasing inventories and some other business payments.

 Loans to individuals: include credit to finance the purchase of
automobiles, apartments, and retail goods, to repair and modernize
homes and other personal purposes.
 Miscellaneous loans: are other credit not listed above, including
securities’ loans.
• In terms of credit objects:
 Working capital credit: is used to build up the working capital of
enterprises including inventories and receivables. Term of this kind
credit is usually short or medium.
 Fixed capital credit: is used to form fixed assets, for instances,
purchasing fixed assets, improving technology, executing new
projects. The term of this kind credit is commonly medium or long
term.
• In terms of currency:
 Credit in domestic currency: is often employed for investments and
transactions domestically.
 Credit in foreign currency: is often employed to make payments for
foreign suppliers and partners and other foreign-currency-related
businesses. This credit is heavily affected by currency risk caused by
exchange rate fluctuation and the home government’s economic
policy regarding foreign currencies.

1.1.1.3. Roles of bank credit in the economy
Lending to businesses, governments, and individuals is one of the most
important economic functions banks and their competitors provide, and it is also


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among the riskiest as our Vietnamese economy has demonstrated through bad credit

crisis recently.
Fist of all, bank credit activity plays an important part in the growth and
stability of a national economy. The increase rate of credit directly relates to GDP of
one nation and other crucial ratios reflecting health of the economy like: growth rate
of total payment and inflation rate. Hence, if bank credit has a reasonable growth
rate, it would help develop the whole economy as expected, lessen the pressure of
incrementing total payment and limit factors causing inflation.
Moreover, bank credit is recruited by Center Banks to control the volume of
money circulation. For instance, by controlling the credit growth rate of each bank
group, State Bank of Vietnam has been achieving the objectives of its monetary
policy, controlling market fluctuation and preventing some market risks.
In implementing other economic programs of the Government including:
enhancing export and manufacture sectors, supporting education and agriculture,
bank credit also servers as a useful and effective tool. Especially, in some projects
such as transportation constructions, technological innovations and researches in
basic sciences, bank credit is considered as key sponsor beside other international
funds.
Because credits support the growth of new businesses and jobs within the
lenders’ market area, how well a lender performs in fulfilling the lending function
has a great deal to do with the economic health of its region. Borrowing operations
bridge the gap between the expenditure requirements and income receipts in the
production economy. As in any voluntary exchange, a credit transaction benefits
both parties to a transaction. The borrower may use the proceeds to buy some
consumer goods or services. A business firm may borrow to put the loan proceeds to
work in income-producing assets such as raw materials, inventories, machinery or
securities which are expected to earn in due course more than the amount borrowed.
The lender in turn receives the interest as remuneration for his expenses and for


8

bearing the risks that unforeseen developments may cause payment of principal or
interest or both to be delayed or defaulted.
Finally, bank credit frequently conveys information to the market place about
borrowers’ credit quality, often enabling a borrower whose credit is approved to
obtain more and somewhat cheaper funds from other sources as well.

1.1.1.4. Bank credit risk
Credit risk is most simply defined as the potential that a bank borrower or
counterparty will fail to meet its obligations in accordance with agreed terms. Of all
the risks banks encounter in their intermediation processes, credit risk poses greater
threat to their vulnerability and sustainability. It has got two distinct facets:
•

Risk from the macro credit portfolio management perspective; and

•

Risk inherent in the individual loan account

Banks nowadays are increasingly facing credit risk (or counterparty risk) in
various financial instruments other than loans, including acceptances, interbank
transactions, trade financing, foreign exchange transactions, financial futures,
swaps, bonds, equities, options, and in the extension of commitments and
guarantees, and the settlement of transactions. However, for most banks, loans are
the largest and most obvious source of credit risk.
Since exposure to credit risk continues to be the leading source of problems
in banks world-wide, banks and their supervisors should be able to draw useful
lessons from past experiences. Banks should now have a keen awareness of the
need to identify, measure, monitor and control credit risk as well as to determine

that they hold adequate capital against these risks and that they are adequately
compensated for risks incurred.
The goal of credit risk management is to maximize a bank’s risk-adjusted
rate of return by maintaining credit risk exposure within acceptable parameters.
Banks need to manage the credit risk inherent in the entire portfolio as well as the
risk in individual credits or transactions. Banks should also consider the


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relationships between credit risk and other risks. The effective management of
credit risk is a critical component of a comprehensive approach to risk management
and essential to the long-term success of any banking organization.
Although specific credit risk management practices may differ among banks
depending upon the nature and complexity of their credit activities, a
comprehensive credit risk management program will address these four areas:
• Establishing an appropriate credit risk environment;
• Operating under a sound credit granting process;
• Maintaining an appropriate credit administration, measurement and
monitoring process; and
• Ensuring adequate controls over credit risk
These practices should also be applied in conjunction with sound practices
related to the assessment of asset quality, the adequacy of provisions and reserves,
and the disclosure of credit risk.

1.1.2. Credit for individual customers
1.1.2.1. The concept of credit for individual customers
a. Definition
Credits for individuals also called personal credit or personal lending is an
amount of money lent to an individual (both on secured and unsecured basis) for

personal, family, or household purposes. It is commonly to finance the purchase of
automobiles, mobile homes, appliances and other retail goods, to repair and
modernize homes, and to cover the cost of medical care and other personal
expenses, and are either extended directly to individuals or indirectly through retail
dealers.
Personal loans are monitored by government regulatory agencies for their
compliance with consumer protection regulations. The credit score of the borrower
is a major component in underwriting and interest rates (APR) of these loans. The
monthly payments of personal loans can be decreased by selecting longer payment
terms, but overall interest paid increases as well.


10

b. Characteristics of credit for individual customers
• High interest rate risk
Most types of personal credits have grown explosively in recent year, fed by
a growing economy and intense competition among banks. By and large, banks
regard credits for individuals and entrepreneurs profitable with “sticky” interest
rates. That is, they are typically priced well above the cost of funding them, but
their contract interest rates often don’t change readily with market conditions as do
interest rates on most business loans. This means that many personal credits are
exposed to significant interest rate risk.
• High lending interest rate
Personal loans are usually priced so high (with a large risk premium built
into the loan rate) that market interest rates on borrowed funds and defaults rates on
the loans themselves would have to rise substantially before most personal credits
would become unprofitable.
• Cyclical sensitivity
Personal loans are among the most costly and most risky to make per dollar

of loan-able-funds committed to them. It also tend to be the cyclically sensitive.
They rise in periods of economic expansion when consumers are generally more
optimistic about the future. On the other hand, when the economy turns down, many
individuals become more pessimistic about the future and reduce their borrowing
accordingly.
• Interest inelastic borrowers
Household borrowings appear to be relatively inelastic, that is, individual
customers are often more concerned about the size of monthly payment required by
a loan agreement than the interest rate charged (though, obviously, the contract rate
on a loan influences the size of its required payments).
• Influences of education and income levels


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While the level of interest rates is often not a significant conscious factor
among household borrowers, both education and income levels do materially
influence consumers’ use of credit. Individuals with higher incomes tend to borrow
more in total and relative to the size of their annual incomes. Those households in
which the principal breadwinner has more years of formal education also tend to
borrow more heavily relative to their level of income. For these individuals
borrowing is often viewed as a tool to achieve a desired standard of living rather
than as a safety net to be used only in emergencies.

1.1.2.2. Classification of credit for individual customers
We can classify personal credits by purpose – what the borrowed funds will
be used for – or by type – whether the borrower must repay in installments or repay
in one lump sum when the loan comes due. Commonly, loans to individuals and
families my be divided into two groups, depending upon whether they finance the
purchase of new homes with a residential loan or whether they finance other, nonhousing activities through nonresidential loans.

• Residential loans:
Credit to finance the purchase of a home or fund improvements on a private
residence comes under the label of residential mortgage loans. The purchase of
residential property in the form of houses and multifamily dwellings usually gives
rise to a long-term loan, typically bearing a term of 15 to 30 years and secured by
the property itself. Such loans may carry either a fixed interest rate or a variable
(floating) interest rate that changes periodically with a specified base rate or a
national mortgage interest rate. A commitment fee, typically 1 to 2 percent of the
face amount of the loan, is routinely charged up front to assure the borrower that a
residential loan will be available for a stimulated period.
• Nonresidential loans:
Within the nonresidential category, personal loans are often divided into
subcategories based on type of loan – installment loans (such as auto or education


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loans); non-installment loans (such as cash advance); and revolving credit loans
(including credit card loans).
 Installment loans:
They are short-term to medium-term loans, repayable in two or more
consecutive payments (usually monthly or quarterly). Such loans are frequently
employed to buy big-ticket items (automobiles, furniture and home appliances) or to
consolidate existing household debts.
 Non-installment loans:
Short-term loans individuals draw upon for immediate cash needs that are
repayable in a lump sum are known as non-installment loans. Such loans my be for
relatively small amounts and include charge accounts that often require payment in
30 days or some other relatively short time period. It may also be made for a short
period (usually six months or less) to wealthier individuals and can be quite large;

for example, the loans to finance the cost of vacations, medical care, the purchase of
home appliance, auto and home repairs.
 Revolving credit loans:
One of the most popular forms of personal credit today is accessed via credit
cards issued by VISA, MasterCard, Discover, and many other card companies.
Credit cards provide convenience and a revolving line of credit the customer can
access when ever the need arises. Credit cards offer their holders access to either
installment or non-installment credit because the customer can charge a purchase on
the account represented by the card and pay off the charge in one billing period,
escaping any finance charge, or choose to pay off the purchase price gradually,
incurring a monthly finance charge based on an annual interest rate usually ranging
from about 10 percent to 24 percent and sometime more. Today, majority number of
credit cards has variable rates of interest.
Card companies find that installment users of credit cards are far more
profitable due to the interest income they generate than are non-installment users,
who quickly pay off their charges before interest can be assessed. Card providers


13

also earn discount fees from merchants who accept their cards. That is the reason
why a rapidly increasing number of the acceptance of charge cards is opened today.

1.1.2.3. Roles of credit for individual customers
• For individual customers
With personal credit, individuals can enjoy wealthier lives while they have
not saved enough money, especially for expensive and emergent expenses such as
medical care and education.
For the youth and low income people, personal credit helps them finance for
necessary consumptions to stabilize lives. Therefore, they have conditions to

develop themselves and contribute more to the society.
However, if personal credit is overused, maybe it causes over-expense and
reduces savings and future consumption.
• For commercial bank
Personal credit is one of crucial tools for banks widening their relationships
with customers, resulting bigger volume of individual deposits and higher profit
from other services for individual customers.
Banks diversify their risks from wholesale banking to retail banking
activities which serve individuals and families and have more opportunities to
broaden their market share.
• For the economy
If personal credit is employed as a useful financial tool to finance the
consumption of domestic goods and services, it can stimulate national demand and
the growth of the economy as a whole. Otherwise, it may reduce the national
savings and cause some troubles.
On the enterprises’ view, personal credit pulls future demand back ward,
helps for the purchase of finished goods, so then raising the scale and scope of
manufacturing, increasing the quality and quantity of products. Thus, the economy’s


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production, distribution and consumption are moving faster and more effectively,
which is base of the economic growth.
Personal credit also clears out the cycle: low income – low level of savings –
low productivity which leads to the decline of unemployment rate and higher
standard of livings.

1.2. Credit appraisal for individual customers in commercial banks
1.2.1. Concept and characteristics of credit appraisal

1.2.1.1. Concept of credit appraisal
Credit appraisal is the process by which a lender appraises the technical
feasibility, economic viability and bankability including creditworthiness of the
prospective borrower. Credit appraisal process of a customer lies in assessing if that
customer is liable to repay the loan amount in the stipulated time, or not.
Each bank has their own methodology to determine if a borrower is
creditworthy or not. It is determined in terms of the norms and standards set by the
banks. Being a very crucial step in the sanctioning of a loan, the borrower needs to
be very careful in planning his financing modes. However, the borrower alone
doesn’t have to do all the hard work. The banks need to be cautious, lest they end up
increasing their risk exposure. All banks employ their own unique objective,
subjective, financial and non-financial techniques to evaluate the creditworthiness
of their customers.

1.2.1.2. General characteristics of credit appraisal
Credit appraisal is an important phase in the origination cycle as decisions
made here affect the health of the portfolio. Incorrect decisions increase the risk and
may add to bad debts affecting the portfolio performance.
The techniques for credit appraisal can broadly be classified into two
categories: Traditional approaches and Modern approaches
a. Traditional approaches


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The traditional approaches focus on some broad parameters to determine
whether the creditworthiness of the borrower. One of the common traditional
approaches is the Expert system or the Five Cs approach.
• Expert System or Five C's of Credit
Every credit proposal, howsoever, small or big, is backed by an entrepreneur.

Every project which may be considered technically feasible, economically viable
and financially sound may run into difficulties if it is not backed by a competent
person who understands the risk and is willing to take and manage them. Thus, the
man behind the project is always the key to understanding the risk in a credit
application. Confidence is the basis of all credit transactions. This is cornerstone of
every credit application. A lack of confidence in the management leads to an
outright rejection of the credit proposal. The basis of this confidence is generally
derived from the 5 ‘C’s of the borrower: character, capacity, capital, collateral and
conditions. In addition to the 5C's reliability, responsibility and resources are also
looked into for gaining the confidence.
 Character
Character is the greatest and the most important asset, which is assessed first.
It is the character of the borrower, which indicates his intention to repay and is key,
even if a borrower has the capacity and capital to repay a loan. A questionable
integrity would make every banker shun him, even if backed by sufficient
collaterals. Character of a borrower is constituted by honesty, sobriety, good habits,
personality, the ability and willingness to keep his word under all circumstances,
reputation of the people with whom he deals etc.
 Capacity
It deals with the ability of the borrower to manage an enterprise or venture
successfully with the resources available to him. The management team’s
educational, technical and professional qualifications, antecedents/the past track
record of the enterprise, present activity, experience in the line of business,


16

experiences of the family, special skill or knowledge possessed by him/the
collective knowledge base of the enterprise, his past record etc. would give a insight
into his capacity to manage the show successfully and repay the loan.

 Capital
It is the amount of owned funds involved in the business as well as his ability
to meet the loss, if any, sustained in the business or venture from his own
investment or capital without shifting it to his creditor or banker. Unless a borrower
has some stake in the business, he may not take much interest in its success.
 Collateral
Collateral refers to the security provided by the borrower in a credit
transaction. The fact that the collateral may be seized by the bank acts as a
motivator to the borrower to repay the loan as per the terms and conditions of the
loan agreement.
 Conditions
Conditions mean the external factors which are beyond the control of the
borrower but which may affect his ability to repay the loan. These include
economic, social, political, competitive and technological conditions. Though these
are not under the control of the borrower, it helps to judge the sensitivity of the
borrower to changes in these conditions. If the borrower is too sensitive to any of
these conditions his repayment capability may be adversely affected as a result of
adverse changes in conditions
b. Modern Approaches
The modern approaches for credit appraisal are statistical in nature. These
approaches are more objective as they are based on some statistical model. One of
the commonly used approach is credit scoring.
• Credit Scoring
Traditionally banks were using the method of analyzing the financial
statement of the applicants by which the bank was able to evaluate the applicant’s