Learning objective: Bank Lending Policy

and Loan Types

Understand the importance of the lending policy

Bank Lending Policy Identify types of loans

Managing Risk

and Loan Types Loan Policy

What
Scope of Credit Investigation
Workout Arrangements

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Banks Balance Sheet The importance of bank lending

Assets Liabilities Loans are major proportion of bank assets
Cash Balance due to other banks
Balance due to Central Bank
Balance due from other banks Earnings from the bank lending activities are a prime source of bank
Customer deposits
Balance due from Central bank Certificates of deposit revenues
Government Investments Long term debt / Bonds Interest, fee income and investment income
Loans and Advances Derivative instruments Client relationships are established and strengthened by lending funds
Derivative instruments Other borrowings to creditworthy borrowers
Investments Equity The bank will likely want repeat lending to that client if they are creditworthy
Share capital
Fixed Assets Lending programs facilitate the cross selling of other bank services
Reserves
Other assets like foreign exchange, funds management, insurance/hedging
Retained earnings

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 Effect of lending on the banks balance
Importance of lending sheet
Banks have a responsibility to meet the legitimate borrowing needs of Major asset category is loans & advances
the community About 60% to 75% of banks assets
wealth: The type of loans granted has flow on effect that has significant
What are the risks undertaken and returns obtained? implications for bank
The more funds allocated to the loan portfolio increases the expected profitability
of the bank
But the larger the loan portfolio the more capital regulators require to be allocated Can add to the liquidity of the bank through regular principal and interest
as a buffer against loan losses (i.e. capital required is a % of assets) repayments

Additional lending may add to bank risk Bank may look to secondary market to sell some loans to generate
Risk and return must be considered in making a lending decision cash flow
Securitisation
RISK how creditworthy are the borrowers?

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Question Bank finance

Tri Bank and Can Bank each have 40% of their assets in loans to Banks provide a whole range of products and services
Governments.
There are a number of segments in bank lending
Good or Bad News? Wholesale and corporate/business
You need more information
Consumer
You find that Government
International
Importance of a particular segment of the market seems to fluctuate
What is the implication of this? from time to time
Risk
Creditworthiness

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Wholesale and corporate/business market Lending to Business
Offshore & domestic finance Finding prospective customers
Most are existing but some banks still cold call
Amounts are very large
Do not need many staff Evaluating loan requests

Loan consortiums Making site visits

Lending characterised by great competition between banks Evaluating ability to repay debt

Very little customer loyalty to any bank Assessing security offered

Price is the key

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Business firms (mid size) Small business

A client usually remains with a bank for some time The owner of the small business see the bank as the only source of
Possibly due to a lack of financial expertise or because they have an existing funds
relationship
Rely heavily on a successful banking relationship
Banks usually advisers
Look to the banks for advice and funds
Price seems to be less important
Customer loyalty is key
Key is service and products offered
Less sensitive to interest rates
Provision of international activities can help banks
Higher risk lending for banks
Security and cash flow are very important from banks side
Repayment of loans may be cashflow driven

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Major types of loans to business Consumer finance
Short term Mainly limited to non price competition
Self liquidating inventory loans
Working capital Competing on price, package, convenience
Interim construction loans Home loan is the key
Cross sell other products like credit card
Long term
Term Loans Many banks segment this market into high net worth customers and
Revolving credit the rest
Project loans More in lecture 5

Syndicated loans
Loan offered by a group of lenders referred to as a syndicate i.e. Two or more
lenders jointly provide loans for one or more borrowers on the same loan terms

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Failure to manage risk Concept questions

Without a clear risk management strategy lenders may be prone to What is the aim of bank lending?
become like "boiled frogs" Lend to creditworthy customers to provide income and profitable business for the
bank
Lenders who gradually move down market may, in time, and without
realising it, accept levels of risk that could boil them What is the major concern of banks in lending?
Many banks have been partially boiled over the past few years through failure to Getting their money bank on time - Credit risk
manage risk appropriately
How can banks reduce risk?
American home loan problem is just one example
Credit evaluation
Take security
Portfolio of loans

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Managing credit risk = Loan Policy Banks loan policy
Requires clear credit philosophy = loan policy Establishes its overall lending risk
Target loan to asset ratio
Management sets priorities for loans
Supported by appropriate credit culture Outlines those loans that are acceptable or unacceptable within the
Goal is alignment of individual behaviour with management priorities
banks risk profile

Credit Culture Procedures for minimising the risks associated with specific types of
loans
"the unique combination of policies, practices, experience, and management
Car loans, real estate, construction, international
Loan policy explains how to price risk

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Banks loan policy Banks loan policy

Sets overall lending strategy for a bank The loan policy is a written document to ensure unambiguous
communication of priorities
Sets the risk profile for bank
Takes into account differences in credit risks for capital adequacy Policy will change over time in response to cultural and economic
Mix of loan portfolio shifts
Policy reflects lending philosophy and culture Should adapt to changes in business cycle and economy
Indicating priorities Routine review of loan policy is crucial
Specifying procedures What is working and what is not?
Monitoring lending activity Policy is to ensure bank officer does what is right for bank
not the bank officer i.e. guide to conflict of interest

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Contents of a banks loan policy Statement of objectives
Statement of objectives General statement to set broad policy objectives and quantify the
banks strategies
Delegation of lending authority
Could set risk levels for certain types of loans
Areas of operations/geographic limits
Set the loan mix (diversification)
Types of loans to be made
Aim to reduce level of default risk associated with large concentrations
Acceptable security/creditworthiness Set risk levels for certain types of loans
Administration of policy Only 5% construction loans: 90% of units to be sold of plan before funding

Other areas Objectives of banks liquidity strategy should be indicated

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Objectives are shaped by: Delegation of lending authority

The bank's strengths and weaknesses, such as the expertise of the
bank personnel.
The economic environment, such as the nature of the available
financial resources.
The potential for growth within the bank's designated market area.
The personal values of the institution's key management, such as
conservatism or aggressiveness.
Board of directors delegate lending approval limits to individuals and
groups
Limit applies to total obligations of a borrower not the amount of the loan
Lending approval limits depend on
Experience, responsibility/ position, type of loan, secured/ unsecured.
Limits for individual tend to be small
Several lending staff meeting together forms a credit committee

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Loan/credit Committees Loan Committees
A number of staff meet as an assigned group to consider loan There may be a special approval committee for very large loans and
applications international loans
Called a loan or credit committee
Banks will also establish special asset/loan committee that monitors
Consists of senior bank loan officers
problem loans
They each individually evaluate the loan and then discuss if to lend or not Usually there is a separate committee for international loans
As a committee they approve loans over a certain size $
individual limits
Reviews major loans approved by bank employees Credit committees meet on a regular basis

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Loan Policy - Operation and Security Question

Areas of Operation/Geographic limitations What would be good to take as security for a loan?
Is bank prepared to lend to x Inventory for a long term loan
International operations need to ensure exposure to companies and/or countries Bars of gold
is not over extended An investors shares in companies listed on the share market
Acceptable Security/Creditworthiness Security over a used car or new car
Amount of funds to be advanced on value of asset Security over land and buildings
What is acceptable security? Obtaining a guarantee
Liquidity of security held by bank to recover loan amount / losses
Loans to customers in excess of banks capacity
Should bank use Syndicated loan to spread risk?
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What influences the type of loans? Credit organisation
Type of loans to be made determined after considering Loan divisions
risk of loan type Generate loan business
need for spread of risk Support customers
liquidity
Credit department
type of customer the bank wants
Evaluates creditworthiness and debt capacity
experience and capabilities of bank staff
profitability of loan type Securities department
maturity/ terms Manages legal claims on collateral
trade area (to be serviced by offices) Collections department
Recovers bad debts

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Collections policy Bad debt and review policy

Collections policy is what to do once a loan has been made and the Bad Debt policy
customer does not perform as set out in the loan When is a loan classed as bad?
It would cover how to recovery payments of slow paying customers What procedures should be carried out to recover funds
What to do with non-performing loans How to sell the security
It will not only cover issues of recovering funds lent but what to do if Compensating balances where borrower is also a lender
they do not abide with conditions of the contract
Review Process
How frequently and type of review of loan files

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Administration of policy Credit analysis
Provision for periodic review, evaluation and recommend changes of Credit analysis is required due to the many factors that can lead to the
loan policy non-payment
Guideline within which loan officers work Some reasons for non-payment:
Should not restrain them unduly external factors - fire, storm, earthquakes
Needs to be broad changes in consumer demand
Provision for the "one-off's" technology / competition
staff problems - strikes
Loan Policy is to ensure lending officers promote what is good for the
personal problems
bank and not what the lending officer feels is good for them
The bank lending officer's role in the granting of credit is to attempt to
assess the risk of non-payment
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Major Considerations
Objectives of Credit Evaluation What makes a good loan?
Major purpose Character
determine the ability and willingness of borrower to repay within the terms of the Willingness and ability to repay
contract Capacity
Has the person got the legal capacity to enter into the contract for the firm
The analyst must determine
degree of risk amount of credit to provide Capital/cash
Ability to generate cash flow to repay debt
terms and conditions which will be acceptable
price at which to offer the credit Collateral
Net worth assets & security- does it have and maintain value?
Some factors are very difficult to evaluate
Conditions
this is the most important part of the analysis
Assessing external and internal conditions within which the business operates

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Character Character continued
Most difficult area to make a judgement Function of a person's honesty and integrity
ascertain the willingness to repay all debts
Just as important in a business firm
Judge - customers desire to settle all obligations
A person of character usually possesses Past record usually weighted heavily in evaluating their character
honesty Assessment of character is largely a matter of judgement, unsupported by
integrity extensive factual information
morality
Personal equation - impression given by face to face contact
Possible not to have all of the qualities but still wish to repay the
financial obligations

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Capacity Capacity continued

Includes ability of borrower to enter into a binding contract (legal Does the company have the authority to borrow, if so who must sign
capacity to borrow) two directors, director and secretary;
common seal affixed to the loan documentation.
Lending to a partnership or firm:
partnerships are similar to individuals / get all partners to sign Sometimes banks require other creditors to rank behind the bank loan
Purpose of the loan- business use? subordinated

Lending to a company: Need other creditor(s) to agree

copy of the Memorandum & Articles of Association deed of postponement or some formal documented agreement
authorised powers of attorney
specific agreements such as shareholders agreement

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Capital / cash flow Capital / cash flow continued
Ability to repay the proposed borrowings power to generate income depends on
Sales Volume / Selling prices
Fixed and variable costs / expenses
Location of business
Sometimes loan will be repaid from the sale of an asset Quality of its goods or services
bridging finance Competition / market position
Advertising
Labour supply / staff moral
Management
Many analysts believe key is evaluation of management
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Capital / cash flow continued Collateral

used in producing income Secondary source of repayment
Rare for financier to provide funds/credit to a business or venture unless equity
capital has been contributed by the owners of the business
Security over assets such as:
property / assets of the business
Important measure of financial strength shares / cash deposits
Balance sheet: assets = liabilities + owners equity Other types - guarantees from third parties
How much of the business is owned by: directors or related/parent entities
the proprietors/shareholders (i.e. their equity)? Important to remember that the primary source of repayment
creditors or outside interests? cashflow from the borrower

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Conditions Conditions continued
Assessing external and internal conditions within which the business Lending officers need to understand how economic conditions affect
operates the borrower
Longer the term - more important economic factors
External risks
Beyond control of the borrower Internal risks
Client may appear acceptable to extend credit but economic conditions make it business reliant on one major
unwise to lend supplier/ customer / project
outlook for the industry and/or economic outlook is business moving with the times?
cyclical type of business is there a market for the products?
position within the industry, i.e. new arrival leader
ability to meet demand (production capacity)
strength of competition

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Scope of the Credit Investigation Scope of Investigation

Will vary from loan to loan and depend on: Business investigation: Like to know something about the history of
size of the loan and maturity the business
previous dealings with the applicant
Would cover:
perceived risk operating record
collateral (security) offered labour relations
No set way of acquiring information development/marketing of products
growth of sales
It may be the practice of a bank that:
companies should have a Dun & Bradstreet or Australian ratings report e.g. from
Standard & Poors or Moodys.

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Scope of Investigation continued Scope of Investigation continued
Key to business success is the quality of management Business loan bank should know
Analyst will look at the following areas: nature and operation of business
Experience / background / outside associations types of products or service
Seek outside opinions demand for product -fad/seasonal/regular
supply of materials
Management succession plan is important
market/distribution methods
Family business may be problem
likely hazards in the business/industry
Business investigation
Extent of investigation will depend on term and amount of the loan Must understand the position of the firm in the industry and impact of
other competitors

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Scope of Investigation Interview of the loan Applicant

financial statements
feel for the overall running of the business
Valuable pieces of information can be gained from the visit
Checks from other credit providers and suppliers
Reasons for the loan request
Judge ability to service the debt and manage their affairs or business
If request does not meet bank guidelines
may suggest how to restructure the request or other sources of finance
Information obtained during the interview is checked later
Banks own records - histories of all past loans plus requests for loans
Past history can be checked

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External Sources of Credit Information Inspection of Place of Business
Most of this information costs money Applicant should be willing to allow a loan officer to visit their place of
business
Credit rating agencies collect information
makes their evaluation of the credit risk Allow you to inspect operations
reports are confidential available - subscription basis A great deal can be learnt from the visit
Ratings -Standard & Poors, Moodys how well the firm is managed
pure credit rating service how well things are organised
are employees performing effectively
Consumer - Credit Reference Association of Australia (CRAA)
how clean and efficient are the premises and operation
history of borrowers past applications and defaults

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Workout Arrangements Workout Arrangements

Borrower financially stressed Major problem -not a legal device
can enter into a workout: Is workout the way to go?
assuming borrower is honest and attitude is satisfactory
enhanced if sizeable equity in the business extending or redrawing the loan agreement (reduce repayments)
bank requiring borrower to seek assistance/advice from external consultants
Sometimes necessary to grant additional loans
Majority of bank loans are handled on a workout basis
Business loan repayments should not so large that it would reduce the

cash drain on the firm

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Workout Arrangements continued Workout Arrangements
For business firms, advice might include: When loan has reached the problem stage, take steps to secure a
expansion program halted mortgage and a security agreement on every available asset belonging
re-evaluation of its sales policies to the borrower, even second mortgages.
reduction in the salaries of some managers
purchase or sale of another firm
other changes designed to increase net cash flow
(but do not sell the good cash flow producers)
sell unprofitable operations

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