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6 years ago

Collateral-based lending vs cash flow-based lending

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Most of the bank lending in Bangladesh  is backed by collaterals i.e. land or building. While considering to extend loan facility to the borrower, first question that comes to the mind of the banker is: what will be the security? In loan processing short-term assets, such as inventory, account receivables, machinery and equipment are rarely considered as security. Security means immovable properties preferably land, building. It is not the banker's fault, because this culture is dominating the banking sector of the counry. Bankers have learned it from the very beginning of their carrier in the banking sector. As such our bankers fully rely on fixed collaterals. They are used to thinking that if a loan became bad they can recover it by selling out the collateral.

While we always talk about the importance of cash flow in the seminars/symposium, in practice, we do not follow what we say. It is time we changed our mindset while extending loan to the potential borrowers. Ali Reza Iftekhar, MD & CEO of Eastern Bank Ltd, rightly emphasised in an interview with a contemporary newspaper recently that bankers, while extending loan, should give number one importance to business cash flow as the primary source of  repayment.

"Cash flow-based lending is a lending technique based on and backed by the enterprises' cash flow". It is different from conventional asset-based lending where the loan is secured by an enterprise's immovable collaterals. The primary difference between the two types of lending mechanisms is that in asset-based lending, income as a source of repayment is of lesser importance; the loan amount is usually based on the value of the property or asset being offered as collateral and not the capability of the business to generate cash. In cash-based lending, the terms and conditions of the loan and the mode of repayment are based on business cash flow.

In order to make good credit decisions, lenders must know how to analyse financial statements i.e. cash flow statements submitted by loan applicants. Lenders are expected to follow sound risk management practices in the context of commercial credit analysis activities. A review of the company's current position with respect to the existing authorised level of commercial lending activities, capital adequacy position and compliance with commercial credit analysis regulations, guidelines and rulings is essential in determining the creditworthiness of an applicant.

For cash flow-based loans, the loan amount is based on the enterprise's actual revenue generation and capacity to repay. Furthermore, the repayment schedule is based on the timing of the enterprise's cash inflows. For such a loan, collateral can be taken. However, it is not the primary consideration for the loan. 

In developing economies, a major weakness in asset-based lending is that lenders are focused mainly on evaluating the value of the asset. This presents a problem as fixed assets cannot repay a facility. As the ability to make repayment is not taken into account, there are risks for both the lender and borrower. Bankers need to make higher provisions with the threat of bad debts lurking. For the enterprise, there is a risk of going out of business.

In a cash flow-based loan, the documented cash flow and credit rating of the business applicant plays a key role in determining how much or if a business can borrow in the first place. In order to assess appropriately necessary information and a reliable financial statement is prerequisite.

At the end of the day, cash is the only factor that can repay a loan. Collateral is the second way-out if cash is not generated to repay a facility. Typically this takes a long time and involves a lot of expense to convert collateral into cash for the sake of repaying a facility.

To get rid of the loan default culture lenders need to change the mindset from their current focus on collateral-based lending to a cash flow-based approach.

The writer is a banker.

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