The following points highlight the eight main forms of institutional and bank finance. The forms are: 1. Term Loans/Project Finance 2. Loan Transfers 3. Non-Recourse Financing 4. Consortium Lending 5. Loan Participation 6. Bridging Finance 7. Reverse Mortgage 8. Transaction Loans.
Form # 1. Term Loans/Project Finance:
Term loans are granted for acquisition of fixed assets (land, building, machinery and equipment’s) to setup a new industrial unit, or for financing the modernization, expansion or diversification of an existing unit.
The typical features of term loans are as follows:
1. The project is appraised on the basis of a detailed analysis of the borrower’s projected balance sheets, profit and Loss account and fund flow statements (for the period of the loan) to determine the financial viability of the project and its debt servicing capacity. The technical, commercial and managerial viability of the project is also critically examined by the banker before sanctioning a term loan.
2. Term loan is secured by mortgaging the specific fixed assets financed or the entire block of fixed assets of the borrower unit.
3. Term loan is granted for medium term (generally 3 to 5 years) or long-term (over 5 years) and is repaid by the borrower from its cash accruals (net profits and depreciation, etc.) in installments spread over the period of the loan.
4. Equated monthly or quarterly installments (principal and interest) are fixed depending on the projected cash accruals over the loan tenure.
5. Apart from the mortgage of the fixed assets of the unit and guarantee of the promoters, covenants or conditions are also stipulated by the bank for ensuring adherence to the desired financial discipline by the borrowing unit.
6. In case of large sized projects (e.g. infrastructure projects) requiring a large amount of loan for long tenures (10 to 20 years), term loans are granted by a group (consortium) of banks/financial institutions. This also lessens the credit risk of the lenders.
Form # 2. Loan Transfers:
In this type of transactions loans are transferred to an existing third party without the creation of a new company. Technically loans cannot be sold in the same way as tangible assets, but there are three main ways in which the benefits and risks under the loan agreement can be sold to a third party.
1. Novation:
The rights and obligations attached to the loan are cancelled and replaced by new ones whose main effect is to change the identity of the lender.
2. Assignment:
Loans may be assigned by either a statutory or equitable assignment.
3. Sub-Participation:
Rights and obligations are not transferred, but lender enters into a non-recourse, back to back agreement with a third party, the sub-participant whereby the latter pays the lender some or all of amount of the loan in return for a share of the cash flows.
In this type of transaction, the original lender:
i. Has no residual beneficial interest in the principal of the loan and that the sub-participant has no formal recourse to the lender for losses.
ii. Has no obligation to provide further finance.
iii. Does not intentionally bear any losses from interest rate changes.
Form # 3. Non-Recourse Financing:
Project financing is different from conventional direct financing. In relation to conventional direct financing, lenders to the firm look at the firm’s asset portfolio that generates cash flows to service their loans. The assets and their financing are integrated into the firm’s asset and liability portfolios. Often, such loans are not secured by any pledge or collateral security.
The critical distinguishing feature of a project financing is that the project is a distinct legal entity; project assets, project related contracts, and project cash flow are segregated to substantial degree from the sponsoring entity. The financing structure is designed to allocate financial returns and risks efficiently than a conventional financial structure.
In project financing, the sponsors provide at most, limited recourse to cash flows from their other assets that are not part of the project. Also, they typically pledge the project assets, but none of their other assets, to secure the project loans. Project financing arrangements invariably involve strong contractual relationships among multiple parties, and maintaining them at a reasonable cost.
Project financing will usually be cost-effective than conventional direct financing when:
1. Project financing permits a higher degree of leverage than the sponsors could achieve on their own;
2. The increase in leverage produces tax shield benefits sufficient to offset the higher cost of debt funds, resulting in a lower overall cost of capital for the project.
Form # 4. Consortium Lending:
When the individual bank finds it difficult to meet the huge financial requirements of a borrower, it gives rise to multiple banking which may be in the form of ‘consortium lending’. When the financial needs of a single unit are more than a single bank can cater the needs, then more than one bank come together to finance the unit jointly spreading the risk as well as sharing the responsibilities of monitoring and finance.
The arrangement is called the ‘consortium lending’ and it enables the industrial units to mobilize large funds for its operations. This is generally formalized by a consortium agreement. RBI has advised that banks which are lending to units requiring large outlay of funds form a consortium arrangement among banks. Borrowers enjoying funds based limits of Rs.50 crores and above from more than one bank should be brought under the above arrangement. There is no ceiling or number of banks in consortium.
However the share of each bank should be a minimum of five per cent or Rs.one crore whichever is more. It will not be permissible for any bank outside the consortium to extend any additional credit facility or open current account for the borrowers without the knowledge and concurrence of the consortium members. Consortium lending is a conventional wedlock that binds all the banks towards the fulfillment of a single project.
It, therefore, involves joint finance by more than one bank/financial institution to the same party against a common security. All the participating banks/institution have a ‘pari passu’ charge on the security. In case of consortium lending, there is a consortium leader who may be known as the ‘lead banker’.
It is the lead banker who receives the proposal, arranges due diligence studies, approves, arranges for documentation, arranges for disbursals from various members, arranges recoveries from the lendees etc. on behalf of all the participant members.
The consortium members may also appoint a lenders’ engineer, to study the project feasibility and economics from their side and also to supervise proper utilization of funds lent and ensure implementation of the project as per schedule. The lenders’ engineer will be paid by the lendee, but will work for the lenders. In this arrangement, the borrower need not submit details to each banker separately in different forms.
Form # 5. Loan Participation:
A syndicated loan is a loan, which is provided collectively by a group of banks. The basic principle underlying loan syndication is ‘risk spreading’ as the size of individual loans increased, individual banks find it difficult to undertake the risk single handed, hence the practice of inviting other banks to participate in the loan, to form a syndicate came into being. In the absence of the syndication facility, the borrowers would have to negotiate a series of individual – loans to meet large requirements.
Syndicated currency loans have developed into one of the most important sources for international lending. Syndicates of banks grant credit funds in the form of loans, lines of credit and other forms of long-term credit. The RBI guidelines signaled formation of loan syndication as a part of lending system.
There are two methods of syndication:
1. Direct Lending and
2. Through Participation.
1. Direct Lending:
In respect of ‘direct lending’ all the lenders sign the loan agreement independently with the borrower and agree to lend upto their respective share. The obligations of the syndicate members are several and they do not underwrite one another.
2. Through Participation:
In this method of lending the lead bank is the only lending bank, so far as the borrower is concerned, that approaches the other lenders to participate in the loan. This normally takes place without the knowledge of the borrower. The lead bank grants a certain portion of the loan to each participant as agreed. It also agrees to pay to the participants a pro rata share of receipts from the borrower.
There can be four types of loan participation by banks and financial institutions:
1. Substitution:
There is an agreement the borrower and the lead bank and other participants to permit the lead bank to disburse the loan on behalf of the participants.
2. Undisclosed Agency:
Here, the lead bank is appointed as agent by the syndicate before the loan is signed, but does not disclose this fact to the borrower. It is, therefore, the principal as far as the borrower is concerned.
3. Sub-Loan:
Under this method, each participant grants a loan directly to the lead bank on the condition that the lead bank repays only to the extent of receipts from the borrower.
4. Assignment:
The lead bank assigns a proportion of the loan and of the benefit of the loan agreement to the participants in consideration of the purchase price or pro rata share of the loan to be contributed by them.
Form # 6. Bridging Finance:
Bridge loans are available from the banks and financial institutions when the source and timing of the funds to be raised is known with certainty. When there is a time gap for access of funds, then for speeding up of implementation of the projects, bridge loans will be provided, such loans are repaid immediately after the raising of funds.
Bridge loans are normally provided by the commercial banks to the corporate for a short period until the disbursement of long-term loans, which are already sanctioned by the financial institutions but disbursal of loan amount takes time.
In case of companies raising funds in the primary capital market, there is a time gap in between the opening of the issue and availability of funds for practical use. In such cases also the companies may go for bridging the finance from commercial banks. The bridge loans are temporary loans which are repaid out of the proceeds which are expected to receive.
The cost of bridge loans is normally higher than the working capital facilities provided by banks and the rate of interest is higher as compared to long-term financing. The bridge loans are secured by having lien on the funds to be raised, hypothecation of movable assets, pledging the promoters shares, personal guarantees from directors, demand promissory notes.
Development Financial Institutions have two schemes known as ‘bridge finance’ for meeting the urgent and emergent requirements. Under the first scheme, the financing is done under term loan and under the second scheme, the financing is done against the underwriting of share issue, if the Development Financial Institutions are satisfied about the reasons for a delay in making the public issue. At present RBI has put a restriction on the banks in giving bridge loans to curb the malpractices in capital market dealings.
Form # 7. Reverse Mortgage:
Conceptually, reverse mortgage seeks to monetize the house as an asset and specifically the owner’s equity in the house. The scheme enables senior citizens to avail of periodical payments from a lender against the mortgage of their house while remaining the owner and occupying the house. Senior citizen borrowers are not required to service the loan during their life and, therefore, do not make any repayments of principal and interest to the lender.
Over the course of time, the balance of reverse mortgage loan will increase along with interest component while equity in the home decreases. On the borrowers’ death or on the borrowers leaving the house property permanently, the loan is repaid along with accumulated interest, through sale of the house property.
The borrowers or heirs can also repay or prepay the loan with accumulated interest and have the mortgage released without resorting to sale of the property.
If senior citizens are looking for a way to supplement their income, a reverse mortgage is a good option. A reverse mortgage allows to tap into home equity to receive money either in a lump sum or monthly payout without losing the ownership of the house and bothering about making payments as long as continuance of living in the home.
As the ownership remains with borrowers, they can transfer their home to their successors too, if the latter agree to pay the loan. A simple definition of reverse mortgage can be: a reverse mortgage is a loan available to seniors and is used to release the home equity in the property as one lump sum or multiple payments.
The homeowner’s obligation to repay the loan is deferred until the owner dies, the home is sold, or the owner leaves. In exercise of the powers conferred by clause (XVI) of Section 47 of the Income-tax Act, 1961 (43 of 1961), the Central Government formulated Reverse Mortgage Scheme, 2008.
Salient Features of the Scheme:
Eligible Lenders:
Reverse Mortgage Loans (RMLs) are to be extended by National Housing Bank established under section 3 of the National Housing Bank Act, 1987, a scheduled bank included in the Second Schedule to the Reserve Bank of India Act, 1934, or a housing finance company registered with the National Housing Bank.
Eligible Borrowers:
According to the Reverse Mortgage Scheme, 2008:
1. The person should be senior citizen of India above 60 years of age.
2. Married couples will be eligible as joint borrowers for financial assistance. In such a case, the age criteria for the couple would be at the discretion of the lenders, subject to atleast one of them being above 60 years of age and the other not below 55 years of age.
3. Should be the owner of a self-acquired, self-occupied residential property (house or flat) located in India, with clear title indicating the prospective borrower’s ownership of the property.
4. The residential property should be free from any encumbrances.
5. The residual life of the property should be atleast 20 years.
6. The prospective borrowers should use that residential property as permanent primary residence. Permanent primary residence refers to the self-Acquired, self-Occupied residential property where a person spends majority of his time.
Form # 8. Transaction Loans:
These loans are provided by the banker for short period for a specific activity like financing for a civil contract work. When the customer receives payment, the transaction loan will be repaid by the customer. The lender will evaluate the ability of the cash flow of the borrower before sanctioning this type of loan.