Importance of customer due diligence as a critical element in the effective management of banking risks

Term ‘Due diligence, ’ is increasingly becoming popular in the financial world. More and more financial analysts are realizing the importance of due diligence process in identifying the risks involved in various transactions. Merchant bankers/ investment bankers engaged in the activities of managing public issues. Acquisition and investment activities have fine-tuned due diligence processes and are using it in a professional manner. However, it has been observed that due diligence is not finding due importance in handling advances by the credit analyst and credit supervisors in the public sector banks in India.

Due diligence has been defined in several ways depending on the requirements of the specific task. As per Wikipedia, due diligence is the effort a party makes to avoid harm to another party and in finance. The term can refer to the activities of pension or investment fund managers. Basically, due diligence would be an attempt to discover all risks and implications regarding a decision to be made. However, these definitions may not be quite relevant in the activity of assuming credit exposure since the main objective of the lender for undertaking due diligence exercise would be to identify the sources of credit risk in time and take appropriate mitigating measures to prevent crystallization of risk.

An attempt is being made in the following paragraph to define the due diligence as applicable in commercial advances.

Term ‘diligence’ has been defined in the dictionary as steady Application, Constant effort, industry or Care. Accordingly, the due diligence process for commercial advances may be defined as ‘a constant process of exercising adequate care as regards to credentials of promoters, veracity of performance and financial position, industry outlook, collateral security, attendant external risks to a credit exposure on a particular entity and other related aspects to a credit-decision’.

Needless to say that the process requires extraordinary time and attention and involves everything from examining the integrity of promoters to understand the market factors which may affect the entity’s performance.

In fact, due diligence is a continuous process in credit management and the people involved in handling credit portfolio should be aware of various aspects of due diligence at different stages of the credit management. Based on various stages of credit management, due diligence process may be segregated in the following phases:

• Appraisal Phase
• Sanction Phase
• Communication of Sanction and Disbursement Phase
• Post-Disbursement Phase
Activities under due diligence in various phases may be overlapping to some extent but the focus would be different. The checklist of activities to be undertaken at various phases of due diligence process is being discussed below.

Appraisal phase of due diligence process needs to cover the following aspects:

The Basel Committee has emphasized the importance of customer due diligence as a critical element in the effective management of banking risks. In a credit exposure not only the credentials of the borrowers are to be ascertained but it is also very important to assess the expertise of the borrowers. It is desirable that the following aspects should be examined and verified.

• Antecedents of the promoters
• Activity proposed is a lawful activity.
• Track record of promoters in meeting payment obligations under LCs/ BGs.
• Performance and track record of associate concerns
• Position regarding RBI’s defaulters/ willful defaulters list. ECGC caution list/ special approval-list.
• Management structure of the entity.
• Systems and procedures for controlling various activities
• In the case of Joint Venture, the JV agreement should also be perused carefully along with examining the antecedents of both the promoters to identify onerous clauses and various risk factors.


While taking any credit exposure on a commercial entity, it is of utmost importance to examine the commercial viability of the venture.

It is, therefore, essential to verify and assess the entity’s performance, both past and future, on the following parameters: 

The top line of any commercial entity is very crucial to its existence. The credit analyst may examine the revenue of a commercial entity thoroughly in the light of following aspects depending upon the merits of the case.

• Trend of sales in past two / three years, current year and next year needs to be analyzed critically

• Generally, trend should not exhibit stagnant sales/ declining sales
• Reasons for non-achievement of estimated/ projected sales, a decline in sales, lower growth as compared to industrial growth must be ascertained and examined critically.
• Low turnover on account of technical defects in the product/ manufacturing process, if any, is a serious concern.
• Non-achievement of estimated sales despite enhancement in w.c. facilities, need to be viewed with circumspect.
• If turnover is not commensurate with the capital invested, reasons thereof need to be analyzed.

The bottom line of a commercial entity is equally important as the future financial strength of the entity would depend on its capacity to generate profit. The entity’s trend in profit during past two/ three years, current year and next year needs to be examined and reasons for the following scenarios should be analyzed critically.


• Net loss in consecutive years.
• Cash losses/ operating losses.
• Low/ poor profitability
• Profits (past & estimates) stagnant despite long experience of the promoters in the line of activity.
• Declining profitability/ steep fall in profits/ profitability.
• A particular division is incurring loss.
• The company is facing marketing problems and has been incurring losses.
• Profits are not commensurate with the capital invested.
• Profitability levels are not being achieved.

Other aspects related to profit should also be examined:

• Overheads are increasing / high operating cost.
• Despite declining sales, overheads are on increase.
• Due to accumulated losses, certain expenses not yet provided.
• Each year a part of expenses is taken into miscellaneous deferred expenditure which is to be written off over a period of time.
• High interest cost.
• Interest costs are on a rising trend.
• Low profitability, weak financial position, inability to service debts through cash generation, unreasonable dividend policy, etc.


Cash accruals determine the unit’s capacity to service the debts. Adequacy and trend of cash accruals need to be examined and care should be exercised in the following circumstances:


• Cash accruals not sufficient to take care of interest and installments.
• Cash accruals much less vis-à-vis estimates.
• Cash losses/ continuous cash losses over a long period.
• Inadequate accruals to service high cost debts.
• Cash accruals are just sufficient to meet the interest obligation.
• DSCR is low.
• Operations yet to generate a surplus to meet the term commitments.

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