Bank Lending to Businesses and Consumers Guide

LENDING TO BUSINESSES AND
CONSUMERS
Chapter 4
◼ A banker is a fellow who lends his

umbrella when the sun is shining and
wants it back the minute it begins to
rain.
(Mark Twain)
- Why?
- How does it affect the borrowers?
- How is the case of Vietnam banks now?
Page 1
17-3
Key topics
A. OVERVIEW OF CREDIT
1. Types of loans banks make
2. Factors affecting the mix of loans made
3. Regulation of lending
4. Steps in the lending process
B. LENDING TO BUSINESSES
1. Types of business loans: short- and long-term
2. Analyzing business loan requests
3. Collateral and contingent liabilities
4. Sources and uses of business funds
5. Pricing business loans
6. Customer profitability analysis (CPA)
C. LENDING TO CONSUMERS
1. Types of loans for individuals and families
2. Unique characteristics of consumer loans
3. Evaluating a consumer loan request
4. Credit cards and credit scoring
5. Disclosure rules and discrimination
6. Loan pricing and refinancing
3
17-4
1. Types of loans banks make
2. Factors affecting the mix of loans made
3. Regulation of lending
4. Steps in the lending process
Page 2
16-5
Types of loans made by banks
◼ Real estate loans
◼ Commercial and industrial loans
◼ Loans to individuals
◼ Financial institution loans
◼ Agriculture loans
◼ Miscellaneous loans
◼ Lease financing receivables
16-6
Loans Outstanding for U.S. Banks (2007)
Page 3
16-7
Factors determining the mix of bank loans
▪ Characteristics of market area: most lenders are

chartered to serve selected markets where they are
located as suburban community (residential real
estate loans, automobile loans, credit for home
appliances) or central city (business loans for
inventory, equipment purchase, business payrolls)
▪ Lender size: legal lending limit to single borrower.

➢ Larger banks → wholesale lenders
➢ Smaller banks → retail credit

7
16-8
Factors determining the mix of bank loans (cont.)

▪ Experience and expertise of management:
commercial banks tend to have experience and
lending policy to make large numbers of commercial
and industrial (business) loans
▪ Expected yield of each type of loan: lenders
prefer to make loans bearing the highest expected
returns (real estate & commercial loans)
▪ Regulations: any loans made are subject to
examination and reviewed and many are restricted or
even prohibited by law.
Page 4
16-9
Asset Quality
◼ Criticized loans: performing well but lender

have minor weakness
◼ Scheduled loans: containing significant

weakness or showing dangerous
concentration of credit in a borrower/industry
16-10
Asset Quality
◼ Adversely classified loans: carrying risk of not

paying out as planned
➢ Substandard loans: margin of protection is
inadequate due to weakness in collateral of the
borrower’s repayment abilities
➢ Doubtful loans: carrying a strong probability of loss
➢ Loss loans: uncollectible or unsuitable to be called

as bankable assets
10
Page 5
16-11
Regulators’ use of market forces
Because the quality of examination information

decays very quickly regulators are starting to
use market forces and private market discipline
(e.g. borrowing costs, stock prices) to monitor
bank behavior.
11
Establishing a Good Written Loan 16-12
Policy
1. Goal statement for bank’s loan portfolio
2. Specification of lending authority of each loan
officer and committee
3. Lines of responsibility in making assignments
and reporting information
4. Operating procedures for soliciting, evaluating
and making loan decisions
5. Required documentation for all loans
6. Lines of authority for maintaining and
reviewing credit files
12
Page 6
16-13
Bank’s Written Loan Policy (cont.)
7. Guidelines for taking and perfecting collateral

8. Procedures for setting loan interest rate
9. Statement of quality standards for all loans
10. Statement of upper limit for total loans
outstanding
11. Description of the bank’s principal trade area
12. Procedures for detecting, analyzing and
working out problem loans
13
16-14
Steps in the lending process

1. Finding prospective loan customers
2. Evaluating a customer’s character and sincerity
of purpose
3. Making site visits and evaluating a customer’s
credit record
4. Evaluating a customer’s financial record
5. Assessing possible loan collateral and signing
the loan agreement
6. Monitoring compliance with the loan agreement
and other customer service needs
14
Page 7
17-15
1. Types of business loans: short- and long-term
2. Analyzing business loan requests
3. Collateral and contingent liabilities
4. Sources and uses of business funds
5. Pricing business loans
6. Customer profitability analysis (CPA)
15
17-16
Short term business loans
1. Self-liquidating inventory loans:
▪ used to finance the purchase of inventory, taking
the advantage of cash cycle in a business firm
▪ Demand for traditional inventory loans is on the
decline due to the development of the JIT (just in
time) and supply chain management techniques
16
Page 8
17-17
Self-liquidating inventory loans:

Cash cycle…
1. Cash is spent to acquire inventory
2. Goods are produced or shelved and listed for

sale
3. Sales are made (often on credit)
4. The cash received is used to repay the self-

liquidating loan
17
17-18
2. Working capital loans: closest to self-liquidating loans

▪ Bank can set up a credit line (max funding need) in a
certain short period (a few months)
▪ Loans can be renewed provided that the borrower pay off
all significant portion of the loan before the renewal
▪ Loans are secured by account receivables, pledges of
inventory
▪ Borrower has to pay floating interest rate on disbursed
amount & a commitment fee is charged on unused credit
line.
▪ Compensating deposit balances may be required.
18
Page 9
17-19
3. Interim construction loans: support the construction

of homes, apartments, office buildings, etc.
▪ Fund supplied to hire workers, lease construction

equipments, purchase building materials & develop land
▪ The loan is paid off with a longer-term mortgage loan

issued by another lender
▪ “Mini-permanent loan” providing fund for the construction

and early operation of a project in 5-7 years
19
17-20

4. Security dealer financing:
▪ short-term (overnight to few days) financing new
securities purchase backed by the dealers’ holdings of
government securities as collateral
▪ Can be extended to investment banking firm in
underwriting new securities issued by the government or
firms
▪ Can be lent directly to businesses and individuals in
buying stocks, bonds, options, etc.
▪ Margin requirements are enforced (≤ 50% of acquired
securities)
20
Page 10
17-21

5. Retailer and Equipment financing:
▪ Banks finance receivables that dealers selling
automobiles, home appliances, furniture, business
equipment,… take on they write installment contracts to
cover customer purchase
▪ Contracts are purchased by lenders at an interest rate
varying with the borrower risk, collateral quality and loan
terms
▪ “Floor planning”: lender finances the dealer’s goods
purchase from manufacturer and be paid as goods are
sold
21
17-22

5. Asset-based financing:
▪ Credit secured by the shorter-term assets of a firm that
are expected to roll over into cash in the future
▪ Lender commits funds against a specific % of book value
of outstanding receivables or inventory
▪ The borrower retains title to the asset pledged in most
cases
▪ Factoring: lender takes on responsibility of collecting
receivables. Due to higher risk → higher discount rate
and loan accounts for a smaller fraction of receivable
book value
22
Page 11
17-23

6. Syndicated loans (SNCs):
▪ Loans package extended to a corporation by a lender
group
▪ Lender aims to reduce risk of large loans and earn fee
income (facility fee to open credit line or commitment fee
to keep credit available)
▪ Many SNC loans are traded in the secondary (resale)
market carrying interest rate based on LIBOR on
Eurodollar deposits (1-4% above LIBOR)
23
17-24
Long-term business loans

1. Term loans
2. Revolving credit lines
3. Project loans
4. Loans to support acquisitions of other business
firms
24
Page 12
17-25
Term loans
Term loans are designed to fund long-term
business investment (equipment or construction)
1. A lump-sum loan is approved
2. Payment is made by amortization monthly/quarterly
3. Repayment source is from business earnings
4. Payment is scheduled based on firm’s cashflow cycle
5. Collateralization is made by fixed assets owned
either by the borrower or the guanrantee
6. Interest rate is either fixed or floated and higher than
short-term rate due to higher risk
7. “Bullet loan”: interest is paid periodically and no
principal is made till maturity date
25
17-26
Term loans:
attention should be paid to….
1. Qualification of the borrower’s management
2. Quality of accounting & auditing system
3. The borrower’s continuous filling in periodical financial
statements
4. The lender’s priority in claiming the borrower’s pledged
assets
5. Adequate insurance coverage
6. The borrower’s risk exposure to technology risk
7. Length of time before the project can generate positive
cash flow
8. Trend in market demand
9. Strength of borrower’s net worth posistion
26
Page 13
17-27
Revolving credit lines

▪ Allowing the customer to borrow up to pre-specified
limit, repay all or a portion of the borrowing and re-
borrow as necessary until the credit line matures
▪ Being one of the most flexible business loan,
granted without specific collateral and maybe short-
term or cover a period as long as 5 years
▪ Useful when firms are uncertain about timing of
future cash flow and borrowing need magnitude
▪ Help even out fluctuations in business cycle
▪ Loan commitment fee is charged on unused portion
of credit line or entire credit amount available
27
17-28
Project loans
▪ The most risky of all business loans to finance fixed
asset construction designed to generate revenue in
future (oil refineries, power plants, harbor facilities…)
▪ Risks are large and numerous, due to
➢ Large funding is involved
➢ Project maybe delayed caused by weather or material
shortage
➢ Laws and regulations in the project location are
negatively changed
➢ Interest rate change adversely affects the ability to pay
▪ Loans are granted to several companies jointly
sponsoring the project and/or the project is co-
financed by several lenders for risk sharing
28
Page 14
17-29
Project loans (cont.)
▪ Project loan may be granted on

▪ Recourse basis: lender can recover funds from the
sponsoring companies if the project fails to repay as
planned
▪ Non-recourse basis: no sponsor guarantees, project

stands or falls on its own merit → higher loan rate and
more sponsor’s capital contribution due to higher risk
29
17-30
Loans to support firm acquisitions
▪ Loans to finance mergers/acquisitions of businesses
▪ Most noted: LBOs (leveraged buyouts)
▪ Firm purchased is financed heavily by debt in the

belief that revenues can be raised higher than debt
costs
▪ Frequently optimistic assumptions have turned to be

wrong and loans have turned delinquent
30
Page 15
Quick quiz
1. How business loans are classified in Vietnam?
2. What are the essential differences between
various short- and long-term business loans?
3. What special problems does business lending

present to the management of a business
lending institution?
31
Loan types (Circular 39/2016/TT-NHNN)

1- Term loan or closed-end credit (Cho vay từng lần): short-
&long-term
2- Syndicated loan (Cho vay hợp vốn): short- &long-term
3- Seasonal loan (Cho vay lưu vụ): short-term
4- Revolving credit line or Lines of credit (Cho vay theo hạn
mức tín dụng): short-term
5- Stand-by credit line loan (Cho vay hạn mức tín dụng dự
phòng): short-term
6- Overdraft loan (Cho vay theo hạn mức thấu chi): short-
term
7- Revolving loan (Cho vay quay vòng): short-term
8 - Rollover loan (Cho vay tuần hoàn): short-term
9 - Combinations of different types mentioned above
32
Page 16
Differences between short- & long-term
business loans
Long - term vs short-term loans:

▪ large volume
▪ long term
▪ high default risk
33
Problems of business loans

Though business loans are usually considered among
the safest types (low default rate), these loans:
➢ average much larger in dollar volume than other
loans → excessive risk of loss and, if a substantial
number of loans fail, can lead to failure
➢ business loans are usually much more complex
financial deals than most other kinds of loans,
requiring larger numbers of personnel with special skills
and knowledge. → increase the magnitude of potential
losses unless the business loan portfolio is managed
with great care & skill.
34
Page 17
17-35
Analyzing business loan application

▪ The lender’s margin for error is narrow, due to:
▪ Large loan denomination
▪ Yield spread reduction because of competition for best

customers
→ requiring special care by
➢ Asking more repayment sources from borrowers
➢ Analyzing the borrower’s financial statements
➢ Pricing the loan correctly to cover costs & be

competitive.
35
17-36
Sources of repayment for business loans
▪ The borrower’s profits or cash flows
▪ Business assets pledged as collateral
▪ Strong balance sheet with ample marketable

assets and net worth
▪ Guarantees given by businesses
36
Page 18
17-37
Analyzing business loan applications
▪ Common size ratios of customer over time
▪ Financial ratio analysis of customer’s financial
statements
▪ Current and pro forma sources and uses of
funds statement
37
Case study - Financial ratio analysis
◼ Analyzing the Black Gold financial statements:

Tables 17.1 → 17.9 (p. 561→ p. 576)
◼ Preparing the cash flow – Pro Forma?
38
Page 19
17-39
Financial ratio analysis

▪ Control over expenses
▪ Operating efficiency
▪ Marketability of product or service
▪ Coverage ratios: measuring adequacy of
earnings
▪ Liquidity indicators for business customers
▪ Profitability indicators
▪ The financial leverage factor as a barometer of
a business firm’s capital structure
39
17-40
Expense control measures
▪ Cost of goods sold/Net sales
▪ Selling, administrative and other expenses/Net

sales
▪ Depreciation expenses/Net sales
▪ Interest expenses on borrowed funds /Net sales
▪ Taxes/Net sales
40
Page 20
17-41
Operating efficiency
▪ Annual costs of goods sold/Average inventory
▪ Average receivables collection period
▪ Net sales/Net fixed assets
▪ Net sales/Total assets
▪ Net sales/Accounts receivables
41
17-42
Marketability of product or service
▪ Gross profit margin=(Net sales-CGS)/Net sales
▪ Net profit margin=Net income after taxes/Net
sales
42
Page 21
17-43
Coverage measures
▪ Interest coverage
▪ Coverage of interest and principal payments
43
17-44
Liquidity measures
▪ Current assets/Current liabilities
▪ Acid test ratio
▪ Working capital
▪ Net liquid assets
44
Page 22
17-45
Profitability measures
▪ Before tax net income/Total assets
▪ After tax net income/Total assets
▪ Before tax net income/Net worth
▪ After tax net income/Net worth
45
17-46
Leverage or capital structure measures
▪ Leverage ratio
▪ Total liabilities/Net worth
▪ Capitalization ratio
▪ Debt to sales ratio
46
Page 23
17-47
Types of contingent liabilities
▪ Guarantees or warrantees behind products
▪ Litigation or pending lawsuits
▪ Unfunded pension liabilities
▪ Taxes owed but unpaid
▪ Limiting regulations
47
17-48
Comprehensive environmental response,

compensation and liability act
This law makes current and past owners of

contaminated property, current and past owners
and prior operators of businesses located on
contaminated property and those who transport
hazardous substances potentially liable.
48
Page 24
17-49
Component of sources and uses of funds

statement
▪ Cash flows from operations
▪ Cash flows from investing activities
▪ Cash flows from financing activities
49
17-50
Traditional (direct) operating cash flows
Net sales revenue – Cost of goods sold – Selling,
general and administrative – Taxes paid in cash
+ Non cash expenses
50
Page 25
17-51
Indirect operating cash flows

Net income
+ Non cash expenses
+ Losses from the sale of assets
– Gains from the sale of assets
– Increases in assets associated with operations
+ Increases in current liabilities associated with
operations
– Decreases in current liabilities associated with
operations
+ Decreases in current assets associated with
operations
51
Ethics in banking
◼ Earning deception by borrowing

businesses: what should loan officers do?
52
Page 26
17-53
Methods used to price business loans
▪ Cost-plus loan pricing method
▪ Price leadership model
▪ Below prime market pricing
▪ Customer profitability analysis
53
17-54
Cost-plus loan pricing
Marginal
Cost of Estimated
Nonfund Bank's
Loan Raising Margin to
Bank Desired
Interest = Loanable + + Compensate +
Operating Profit
Rate Funds to Bank for
Costs Margin
Lend to Default Risk
Borrower
54
Page 27
17-55
Price leadership model
Default
Risk Term Risk
Loan
Base or Premium Premium for
Interest = + +
Prime Rate for Non- Longer
Rate
Prime Term Credit
Borrowers
55
17-56
Prime rate
Major banks established a base lending fee

during the great depression. At that time it was
the lowest interest rate charged their most
credit worthy customers for short-term working
capital loans.
56
Page 28
17-57
LIBOR: London Interbank Offer Rate
The rate offered on short-term Eurodollar
deposits with maturities ranging from a few
days to a few months.
57
17-58
Below-prime market pricing
Interest Cost
Loan Markup
of Borrowing
Interest = + for Risk
in the Money
Rate and Profit
Market
58
Page 29
17-59
Customer profitability analysis (CPA)
▪ Estimate total revenues from loans and other

services
▪ Estimate total expenses from providing net

loanable funds
▪ Estimate net loanable funds
▪ Estimate before tax rate of return by dividing

revenues less expenses by net loanable funds
59
17-60
1. Types of loans for individuals and families
2. Unique characteristics of consumer loans
3. Evaluating a consumer loan request
4. Credit cards and credit scoring
5. Disclosure rules and discrimination
6. Loan pricing and refinancing
60
Page 30
18-61
Consumer lending
▪ Has been among the most popular financial services offered in recent
years
▪ One of the most important sources of revenues and deposits for banks
and their competitors (credit unions, savings associations, and finance
and insurance companies); a source of supplemental income
▪ On the other hand, presents a special challenge due to higher-than-
average default rates.
(life cycle => how important the consumer lending is to people’s life)
61
18-62
Outstanding consumer debt as a percent of
disposable income
62
Page 31
18-63
Consumer debt service ratio
63
18-64
Types of consumer loans
▪ Classify consumer loans by purpose – what

the borrowed funds are used for, or by type –
whether the borrower must repay in
installments or in one lump sum
▪ Residential mortgage loans
▪ Nonresidential loans
➢ Installment loans
➢ Non-installment loans
▪ Credit card loans and revolving credit
64
Page 32
18-65
Residential mortgage loans

▪ Credit to finance the purchase of residential
property in the form of houses and multifamily
dwellings, usually a long-term loan (15-30 years)
which is secured by the property itself.
▪ Fixed or variable rate of interest.

Base rate: US Government Bond or FHLB Board’s average
home mortgage yield
▪ 1-2% commitment fee may be charged
65
18-66
Residential mortgage loans

Lenders:
▪ Banks
▪ Saving associations
▪ Credit union
▪ Finance companies
▪ Insurance companies
▪ Mortgage banking subsidiaries of FHCs
66
Page 33
18-67
Non-residential loans: installment loans

Short-term to medium-term loans repayable in
two or more consecutive payments, usually
monthly or quarterly. These are often used to
finance big-ticket purchases or to consolidate
existing debt (automobile, furniture, appliances).
▪ Direct
➢Negotiated between the bank and the ultimate
user of the funds
▪ Indirect
➢Funded by a bank through a separate retailer
that sells merchandise to a customer
67
18-68
Non-residential loans: Non-installment
loans
▪ Short-term loans (6 months or less) by
individuals for immediate cash needs and
repayable in one lump sum when the
borrower’s note matures
▪ Borrowing amount can be small ($500-$1,000)

or large ($5,000-$50,000)
▪ Loans are used for charge accounts, medical

care, auto and home repairs.
68
Page 34
Non-installment loans
▪ Bridge loans are representative of single

payment consumer loans.
➢ Bridge loans often arise when an individual
borrows funds for the down payment on a new
house
➢ The loan is repaid when the borrower sells the

previous home
69
18-70
Credit card loans

▪ Credit cards issued by card companies as VISA,
MasterCard, American Express, JCB, Diners Club,
etc. offer holders access to either installment or
non-installment credit.
▪ Most banks operate as franchises of MasterCard
and/or Visa
➢ Bank pays a one-time membership fee plus an
annual charge determined by the number of its
customers actively using the cards
▪ Holders may charge their purchase on the account
represented by the card and pay off:
➢ In one billing period, escaping nay finance charge
➢ Pay gradually, incurring a monthly finance charge
based on annually interest rate (2/3 cards have
variable interest rate)
70
Page 35
18-71
Credit card loans

▪ Banks find that the installment users of credit
cards are the most profitable – provide higher
risk-adjusted returns than other types of loans.
▪ Card issuers earn income from:

➢ Cardholders’ annual fees
➢ Interest on outstanding loan balances
➢ Discounting the charges that merchants accept on

purchases.
71
18-72
Credit card loans

▪ Credit cards offer convenience and revolving line of
credit that holders can access whenever they need
▪ Careful management and control is needed due to
relatively rate of delinquent borrowers and large number
of cards stolen and used fraudulently
▪ Only the greatest card operations are consistently
profitable
▪ Credit card program may survive because of advancing
technology giving holders access to full range of
financial services (payment and saving accounts)
72
Page 36
Credit card systems and profitability
◼ Returns depend on the specific role the bank

plays
➢ A bank is called a card bank if it administers its
own credit card plan or serves as the primary
regional agent of a major credit card operation
➢ A non-card bank does not issue its own card
73
Credit card transaction process
Individual 1 Retail Outlet
4 2
Card-Issuing Clearing Local Merchant
Bank 3 Network 3 Bank
2
Steps Fees
1. Individual uses a credit card to purchase 1. None
merchandise from a retail outlet.
2. Retail outlet deposits the sales slip or 2. The merchant bank discounts the sales receipt. A 3
electronically transmits the purchase data percent discount indicates the bank gives the retailer
at its local bank. $97 in credit for each $100 receipt.
3. Local merchant bank forwards the 3. The card-issuing bank charges the merchant bank an
transaction information to a clearing interchange fee equal to 1 to 1.5 percent of the
network, which routes the data to the bank transaction amount for each item handled.
that issued the credit card to the individual.
4. The card-issuing bank sends the individual 4. The card-issuing bank charges the customer interest
an itemized bill for all purchases. and an annual fee for the privilege of using the card.
A card-issuing bank also serves as a merchant bank.
74
Page 37
18-75
Credit card regulations

▪ U.S. regulators of depository institutions - OCC,
Fed, FDIC, and OTS -- in 2003, moved to slow
the expansion of card offers to customers with
low credit ratings
▪ More recently, May 2009:
➢ Strict limits on marketing to college students and other
prospective cardholders under the age of 21
➢ Preventing cardholder accounts from being charged
beyond their limits
➢ Clearer disclosure of credit card interest rates and
repayment estimates, using standard text sizes and
styles
➢ Tougher rules related to raising interest rates on
delinquent cardholders, with clear paths to rehabilitate
credit card accounts.
75
18-76
Debit cards
▪ Debit cards, widely available, can be used to
pay for goods and services, but not to extend
credit. They are a convenient vehicle for making
deposits into and withdrawals from ATMs and
they facilitate check cashing.
▪ When an individual uses the card, their balance
is immediately debited
▪ They have lower processing costs to the bank
▪ Leading firms: First Data Corp. VISA USA Inc.,
MasterCard International Inc.
76
Page 38
18-77
Debit cards
▪ Debit card forces discipline to customers & saves
time and paper work comparing with checks
▪ Debit card provides banks with additional fee

income with lower losses than credit card
77
18-78
Debit cards and Smart card

▪ Close relative of debit cards: smart card
▪ Smart card carries balances that can be spent
electronically in stores until the balance is fully
used up
▪ Contains a memory chip which can manipulate
information
▪ It is programmable such that users can store
information and recall this information when
effecting transactions.
▪ Only modest usage in the U.S.
78
Page 39
Debit Cards and Smart Card
▪ Smart Card: usage will likely increase dramatically

in the U.S.:
➢ Firms can offer a much wider range of services
➢ Smart cards represent a link between the Internet

and real economic activity
➢ Suppliers of smart cards are standardizing the

formats so that all cards work on the same systems
79
Pre-paid cards
◼ Prepaid cards
➢ A hybrid of debit cards in which customers

prepay for services to be rendered and
receive a card against which purchases are
charged
➢ Use of phone cards, prepaid cellular, toll

tags, subway, etc. are growing rapidly
80
Page 40
18-81
Characteristics of consumer loans

▪ Profitable credits with “sticky” interest rate (priced
well above funding cost but kept unchanged in
contract regardless of market conditions)
→ significant interest rate risk
▪ Most costly and most risky to make per dollar
▪ Cyclically sensitive: rise in economic expansion
and reduce in economic downturn
▪ Interest inelastic: borrowers are more concern
about monthly payment than interest rate charged
▪ Influenced by education and income levels:
borrowing is higher in amount with educated
people and well-paid individuals.
81
18-82
Performance and Chargeoffs by Bank Category, 12/2004

5.0%
4.5% 4.01%
4.0%
3.5%
3.0%
2.5%
2.0% 1.66% 1.66%
1.23% 1.30% 1.18% 1.35%
1.5% 1.10%
1.0% 0.76%
0.5%
0.0%
International Agricultural Credit Card Commercial Mortgage Consumer Other All Other < All Other >
Banks Banks Lenders Lenders Lenders Lenders Specialized < $1 Billion $1 Billion
$1 Billion
5.0% 4.67%
4.0%
3.0%
2.0%
1.57%
0.91%
1.0%
0.59%
0.21% 0.30% 0.31% 0.25%
0.12%
0.0%
International Agricultural Credit Card Commercial Mortgage Consumer Other All Other < All Other >
Banks Banks Lenders Lenders Lenders Lenders Specialized < $1 Billion $1 Billion
$1 Billion
82
Page 41
Credit card loss rates and personal
bankruptcy filings: 1984-2004
Net Charge-Off % Personal Bankruptcy Filings $000
9% 450
Credit-Card
8% Charge-Off 400
Rates
7% 350
6%
300
5%
Personal 250
4% Bankruptcy
Filings 200
3%
2% 150
1% 100
0% 50
'84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04
83
18-84
Risks of consumer loans
◼ Risk of consumer loan is higher or

lower compared to business loans?
◼ Why many banks develop products
for consumer customers?
◼ Retailed banking versus consumer
lending?
84
Page 42
18-85
Evaluating a consumer loan application

◼ Getting money is like digging with a
needle; spending it is like water soaking into
sand - Japanese proverb
◼ A bank is a place that will lend you money if

you can prove that you don't need it. ~Bob
Hope
◼ People are living longer than ever before, a

phenomenon undoubtedly made necessary by
the 30-year mortgage. ~Doug Larson
85
18-86

▪ Character and purpose
▪ Income levels
▪ Deposit balances
▪ Employment and residential stability
▪ Pyramiding of debt
▪ How to qualify for a consumer loan?
However, consumer loans differ so much in
design that no comprehensive analytical format
applies to all loans.
86
Page 43
◼ Can you compare 6Cs of consumer loans

and business loans?
◼ Remember: Creditors have better

memories than debtors.
87
Credit analysis
◼ Evaluation procedures:
➢ Judgmental and
➢ Quantitative, Credit Scoring
88
Page 44
Credit analysis: judgmental procedures
◼ Judgmental
➢ The loan officer subjectively interprets the
information in light of the bank’s lending
guidelines and accepts or rejects the loan
89
Credit analysis: quantitative
◼ Quantitative credit scoring / Credit scoring

model
➢ The loan officer grades the loan request
according to a statistically sound model that
assigns points to selected characteristics of
the prospective borrower
◼ In both cases, judgmental and quantitative,
a lending officer collects information
regarding the borrower’s character,
capacity, and collateral
90
Page 45
18-91
Credit scoring
Credit scoring systems are based on
sophisticated statistical models in which several
variables are joined to establish a numerical
score to separate good loans from bad loans.
The most famous of these is the FICO Scoring
System Developed by Fair Isaac.
91
18-92
Credit bureaus
▪ Credit reporting agencies or credit bureaus

assemble and distribute to lenders the credit
history of millions of borrowers
▪ Information
➢ Personal identifying data
➢ Personal credit histories
➢ Public information that may have bearing on loan
92
Page 46
18-93
Credit bureaus in Vietnam
▪ CIC
▪ PCB
93
An application:
for a consumer loan
◼ Case of Skylark application – pp. 601-604
◼ How does the bank analyze Skylark?
◼ What is the conclusion?
◼ Do you make the loan?
94
Page 47
An application:
credit scoring a consumer loan
◼ You receive an application for a customer to
purchase a 2003 Jeep Cherokee
95
An Application: Credit Scoring a Consumer Loan
96
Page 48
97
Example of loan application in

Vietnam
◼ Assessment report of the individual
◼ Pricing assessment report of secured

items
98
Page 49
Quick Quiz
◼ Comparing the assessment of loan

application btw individual and business?
99
Credit scoring system, University

National Bank, applied to credit
application for purchase of a 2003 Jeep
Category Characteristics/Weights
<$10,000 $10,000-$20,000 $20,000-$40,000 $40,000-60,000 >$60,000
Annual Gross Income
5 15 30 45 60
Monthly Debt Payment >40% 30-40% 20-30% 10-20% <10%
Monthly Net Income 0 5 20 35 50
Bank Relationship None Checking Only Saving only Checking & Saving No answer
Checking/Saving 0 30 30 50 0
None 1 or more No answer
Major Credit Cards
0 30 0
Any derogatory within 7 yrs. No record Met obligated payments
Credit History
-10 0 30
< 50 yrs. >50 yrs. No answer
Applicant's Age
5 25 0
Rent Own/Buying Own outright No answer
Residence
15 40 50 15
Residence Stability < 1 yr. 1-2 yrs. 2-4 yrs. >4 yrs. No answer
0 15 35 50 0
Job Stability < 1 yr. 1-2 yrs. 2-4 yrs. >4 yrs. Unemployed Retired
5 20 50 70 5 70
NOTE: Minimum score for automatic credit approval is 200; score for judgmental evaluation, 150 to 1 95; score for
automatic credit denial is less than 150. Melanie Groome's credit score is 185.
100
Page 50
FICO Credit scores
National Distribution of FICO Scores
30
28%
25
20
19%
15 16%
10 12% 11%
5 8%
5%
$% of Population
1%
0 Up to 499 500-549 550-599 600-649 650-699 700-749 750-799 800+
FICO Score Range
Delinquency Rates by FICO Score

100%
80% 87%
71%
60%
51%
40%
31%
20%
15% 5% 2% 1%
0%
Up to 499 500-549 550-599 600-649 650-699 700-749 750-799 800+
Rate of Credit Delinquencies FICO Score Range
101
18-102
102
Page 51
An application: indirect lending
◼ A retailer sells merchandise and takes the credit
application
➢ Because many firms do not have the resources to
carry their receivables, they sell the loans to
banks or other financial institutions
✓ These loans are collectively referred to as dealer
paper
➢ Banks aggressively compete for paper originated
by well-established automobile, mobile home,
and furniture dealers
103

◼ Indirect lending is an attractive form of consumer
lending when a bank deals with reputable retailers
◼ Dealers negotiate finance charges directly with their
customers
➢ A bank, in turn, agrees to purchase the paper at
predetermined rates that vary with the default risk
assumed by the bank, the quality of the assets sold,
and the maturity of the consumer loan
➢ A dealer normally negotiates a higher rate with the
car buyer than the determined rate charged by the
bank
➢ This differential varies with competitive conditions
but potentially represents a significant source of
dealer profit
104
Page 52
◼ Most indirect loan arrangements provide for

dealer reserves that reduce the risk in indirect
lending
➢ The reserves are derived from the differential

between the normal, or contract loan rate and
the bank rate, and help protect the bank
against customer defaults and refunds
105
Terms of the Dealer Agreement

Bank buys dealer paper at a 12 percent rate. Dealer charges customers a higher rate
(15 percent APR), with 25 percent of difference allocated to a reserve.
Sample Automobile Loan
Principal = $8,000
Maturity = 3 years, 36 monthly installments
Loan rate = 15% annual percentage rate (APR)
An Application: Indirect
Monthly payment = $8,000/[(I/.0125) - (1/.0125(l.0125)36)] $277.32

Allocation to the Dealer Reserve
Total interest expense to customer= $1,983.52
Total interest income for bank = 1,565.72
Differential interest - $ 417.80
75% allocated to dealer: 0.75(417.80) = $313.35
25% allocated to reserve: 0.25(417.80) = $104.45
Interest Refunds on Prepayments with Add-on Rates
Loan is written on a precomputed basis, and bank accrues interest using “rule of 78s"*
Interest expense to customer = 0.15($8,000)(3) = $3,600
Interest income for bank = 0.12($8,000)(3) = 2,880
Differential interest = $ 720
75% allocated to dealer: 0.75($720) = $540
Lending
25% allocated to reserve: 0.25($720) = 180

End of Year Interest Earned* Total Bank Difference
1 54.96% $1,978.37 $1,582.70 $395.67
2 33.33 1,200.00 960.00 240.00
3 11.71 421.62 337.30 84.32
100.00% $3,600.00 $2,880.00 $720.00
*Rule of 78s factors are 366/666, 222/666, and 78/666, respectively.
106
Page 53
18-107
Ethics in banking box: identity theft

◼ Fastest growing crime against individuals
today
◼ It can be difficult to detect and costly to
recover from
◼ Fair credit and accurate credit transactions
(FACT) Act was passed in 2003 to counter this
growing problem
◼ Consumers entitled to one free credit report
annually from each of the three major credit
bureaus
107
18-108
Laws and regulations applying to

consumer loans
▪ Disclosure rules
➢ Truth in Lending Act, passed in 1968,
simplified in 1981
➢ Fair Credit Reporting Act, 1974
➢ Fair Credit Billing Act
➢ Fair Debt Collection Practices Act
▪ Antidiscrimination Laws
➢ Equal Credit Opportunity Act
➢ Community Reinvestment Act
➢ Home Ownership and Equity Protection Act
108
Page 54
Consumer credit regulations
▪ Equal credit opportunity

➢ Makes it illegal for lenders to discriminate
➢ Prohibits Information Requests on:

✓ The applicant's marital status
✓ Whether alimony, child support, and public

assistance are included in reported income
✓ A woman's childbearing capability and plans
✓ Whether an applicant has a telephone
109
➢ Credit scoring systems

✓ Credit scoring systems are acceptable if they do
not require prohibited information and are
statistically justified
✓ Credit scoring systems can use information about

age, sex, and marital status as long as these
factors contribute positively to the applicant's
creditworthiness
110
Page 55

➢ Credit scoring systems
✓ Credit scoring models are based on historical data
obtained from applicants who actually received
loans
✓ Statistical techniques assign weights to various
borrower characteristics that represent each
factor's contribution toward distinguishing between
good loans that were repaid on time and problem
loans that produced losses
111

➢ Credit reporting
❖ Lenders must report credit extended jointly to
married couples in both spouses' names
❖ Whenever lenders reject a loan, they must notify

applicants of the credit denial within 30 days and
indicate why the request was turned down
112
Page 56
▪ Truth In Lending
➢ Regulations apply to all individual loans up to
$25,000 where the borrower's primary residence
does not serve as collateral
➢ Requires that lenders disclose to potential
borrowers both the total finance charge and an
annual percentage rate (APR)
✓ The APR equals the total finance charge computed
against the loan balance as a simple annual
interest rate equivalent
113

◼ Fair Credit Reporting Act
➢ Enables individuals to examine their credit
reports provided by credit bureaus
✓ Ifany information is incorrect, the individual can
have the bureau make changes and notify all
lenders who obtained the inaccurate data
➢ There are three primary credit reporting
agencies:
➢ Equifax
➢ Experian
➢ Trans Union
✓ Unfortunately, the credit reports that they produce are
quite often wrong
114
Page 57
Sample Credit Report
115
◼ Fair Credit Reporting Act

➢ Credit score
◼ Like a bond rating for individuals: based on
several factors
Facotor
Contributing to Facotor
Credit Score, Contributing to
Facotor 10% Credit Score,
Contributing to 30.00%
Credit Score,
15%
Facotor Facotor
Contributing to Contributing to
Credit Score, Credit Score,
10% 35%
116
Page 58
▪ Community Reinvestment Act
➢ CRA prohibits redlining and encourages lenders to
extend credit within their immediate trade area and
the markets where they collect deposits
➢ FIRREA of 1989 raised the profile of the CRA by:
❖ Mandating public disclosure of bank lending policies
and regulatory ratings of bank compliance
❖ Regulators must also take lending performance into
account when evaluating a bank's request to charter
a new bank, acquire a bank, open a branch, or
merge with another institution
117

◼ Bankruptcy reform
➢ Individuals who cannot repay their debts on time
can file for bankruptcy and receive court protection
against creditors
➢ Individuals can file for bankruptcy under:
✓ Chapter 7
• Individuals liquidate qualified assets and distribute the
proceeds to creditors
✓ Chapter 13
• An individual works out a repayment plan with court
supervision.
➢ Unfortunately, individuals appear to be using
bankruptcy as a financial planning tool
➢ It appears the stigma of bankruptcy is largely gone
118
Page 59
18-119
Predatory lending and subprime loans
An abusive practice among some lenders that

consists of granting loans to subprime
borrowers and charging them excessive
interest rates and fees, increasing the risk of
default. Subprime lending played important role
in the 2007 financial crisis.
119
Subprime loans
▪ One of the hottest growth areas during the

1990s
➢ Subprime loans are higher-risk loans labeled

“B,” “C,” and “D” credits
✓ They have been especially popular in auto, home
equity, and mortgage lending
✓ Typically have the same risk as loans originated

through consumer finance companies
120
Page 60
Subprime loans
▪ Subprime loans have greater risk and must be priced
consistently higher than prime-grade loans
▪ Example definitions:
✓ B: Typically scores 600+ under the Fair Isaac system; has
some 90-day past dues but is now current. Typical
delinquencies are 2%-5%; repossessions are 2.5%-6%; and
losses are 1.5%-3%
✓ C: Typically scores between 500 and 600 and has had write-
offs and judgments. The borrower has made subsequent
payments of some or all of the loans. Typical delinquencies
are 5%-10%; repossessions, 5%-20%; and losses 3%-10%
✓ D: Typically scores between 440 and 500 and has charge-offs
and judgments that have not been repaid and has not made
payments on these loans. Delinquencies are 10%-20%;
repossessions, 16%-40%; losses, 10%-20%
121
Subprime loans
▪ High LTV Loans
➢ High Loan-To-Value
✓ Many lenders upped the stakes by making “high
LTV” loans based on the equity in a borrower’s
home
✓ Where traditional home equity loans are capped at
75 percent of appraised value minus the
outstanding principal balance, high LTV loans
equal as much as 125% of the value of a home
122
Page 61
18-123
Real estate loans
▪ Among the riskiest loans banks can make
▪ Average size is larger than the average size of

other loans
▪ Tend to have longer maturities than other loans
123
18-124
Factors used in evaluating real estate loans
▪ Size of down payment relative to purchase

price of property
▪ Should be evaluated in terms of total
relationship
▪ Need to pay attention to particular aspects of
credit application:
➢ Amount and stability of income (gross debt service)
➢ Available savings and source of down payment
➢ Track record in maintaining property
➢ Outlook for real estate market in local area
➢ Outlook for interest rates if variable rate loan
124
Page 62
Quick Quiz
◼ Why banks should pay attention to these

factors in evaluating the real estate
loans?
125
18-126
Home equity lending

▪ Home owners can use the difference in home’s
estimated value and remaining mortgages as a
borrowing base
▪ Two types of credit
➢ Closed end credit
➢ Lines of credit
▪ Can be used for any legitimate purpose
▪ The 1986 Tax Reform Act has helped this type of
loan grow in popularity
126
Page 63
18-127
Interest only mortgages: the most

controversial of home mortgage loans
▪ Many of these are adjustable rate mortgages
▪ Home owner can pay the interest only for an
initial period
▪ Mortgage payments can be much higher when
principal payments are due because of the
shorter period to repay the loan
▪ Especially problematic when house prices stop
climbing upward
▪ During the recent crisis, the Fed moved to
tighten the rules on mortgage lending to
promote greater transparency in loan terms
127
Pricing of consumer and real estate

loans
1. Non-residential loans
▪ Cost-plus model
▪ Annual Percentage rate
▪ Simple interest method
▪ The discount rate method
▪ Add-on loan rate method
▪ Rules of 78s
128
Page 64
18-129
Cost-plus model of pricing loans
Risk Risk
Lender's
Loan Rate Nonfunding Premium Premium Desired
Cost of
Paid by = + Operating + for + for Time + Profit
Raising
Consumer Costs Customer to Margin
Funds
Default Maturity
129
18-130
Annual percentage rate (APR)
The APR is the internal rate of return that

equates total payments with the amount of the
loan. The truth in Lending Act requires that this
rate be disclosed to consumers on all loans.
130
Page 65
18-131
Simple interest
In simple interest the customer only pays
interest on the amount of the principal left. First
the declining loan balance is calculated and that
reduced balance is used to calculate the amount
of interest owed
$3,000 loan at 12% simple interest per year produces

$360 in interest, or a 12 percent effective rate interest
(is): = $3,000(0.12)(1)= $360
$3,360
$3,000 =
(1 + is )
is = 12%
131
Simple Interest
▪ Simple Interest
➢ The quoted rate (APR) is adjusted to its monthly
equivalent, which is applied against the unpaid
principal balance on a loan
➢ The loan is repaid in 12 monthly installments

and the monthly interest rate equals 1 percent of
the outstanding principal balance at each month
132
Page 66
Simple interest rate
Repayment Schedule
End of Month Monthly Interest Principal Outstanding
Payment Portion Principal
Balance
January $266.55 $30.00 $236.55 $2,763.45

February 266.55 27.63 238.92 2,524.53
March 266.55 25.25 241.30 2,283.23
April 266.55 22.83 243.72 2,039.51
May 266.55 20.40 246.15 1,793.36
June 266.55 17.93 248.62 1,544.74
July 266.55 15.45 251.10 1,293.64
August 266.55 12.94 253.61 1,040.03
September 266.55 10.40 256.15 783.88
October 266.55 7.84 258.71 525.17
November 266.55 5.25 261.30 263.87
December 266.51 2.64 263.87 0.00
Total $3,198.56 $198.56 $3,000.00
Effective interest rate: Monthly rate = 1%

Annual precentage rate = 12%
12
1
Monthly payment = $3,000  (1.01)
i=1
t
133
18-134
Discount rate method
The discount rate method requires the customer

to pay the interest in advance. Interest is
deducted first and the customer receives the
loan amount less any interest owed
➢Consider a 1-year loan with a single $3,000
payment at maturity.
✓ The borrower receives only $2,640, or the total
loan minus 12% discount rate interest.
✓ The effective annual percentage rate, or APR,
equals 13.64%
▫ Interest charge =Rate
Annual Percentage 0.12(in($3,000) $3,000
) $2,640 == $360
(1+ in )
i = 13.64%
134
Page 67
18-135
Add-on loan rate method
Interest owed is added to the principal amount,

then the loan payments are calculated by
dividing this sum by the number of loan
payments
135
Add-on Rates
◼ Example:
✓ Suppose that a customer borrows $3,000 for one
year at a 12 percent add-on rate with the loan to
be repaid in 12 equal monthly installments
✓ Total interest equals $360, monthly payment
equals $280, and the effective annual interest
cost is approximately 21.5%
[0.12($3,000) + $3,000]
Monthly Payment = = $280
12
12
$280
Effective Interest Rate(i) :  t
= $3,000 i = 21.46%
t=1(1 + i)
136
Page 68
18-137
Rule of 78s
A rule of thumb to determine exactly how much

interest income a bank is entitled to accrue at
any point in time from an installment loan being
paid in monthly
137
Back to the indirect lending
◼ How to calculate the figures?
◼ How is the implication of indirect lending?
138
Page 69
18-139
2. Interest rates on home mortgages

▪ Fixed rate mortgage (FRM) – 1930s to 1970s
most mortgages were fixed-rate mortgages.
They had a fixed interest rate that did not
change over the life of the loan
▪ Adjustable rate mortgage (ARM) – in the early
1970s adjustable rate mortgages were allowed.
These mortgages have an interest rate that
changes over the life of the mortgage. The
yields are more responsive to interest rate
movements – an advantage for the lender.
139
18-140
Mortgage points
This is an additional up front charge often

required on home mortgages. It is a
percentage of the loan amount and reduces the
amount of the loan available
140
Page 70
Questions & Problems – Lending to businesses
1. What special problems does business lending present to

the management of a business lending institution?
2. What are the essential differences among working capital
loans, open credit lines, asset-based loans, term loans,
revolving credit lines, interim financing, project loans, and
acquisition loans?
3. What are contingent liabilities, and why might they be
important in deciding whether to approve or disapprove a
business loan request?
4. What are the principal strengths and weaknesses of the
different loan-pricing methods in use today?
5. Problem 3, 4, 6 and 7 (page 586-8)
141
Questions & Problems – Lending to consumers
6. How do credit-scoring systems work? What are the

principal advantages & disadvantages to a lending
institution of using a credit-scoring system?
7. What factors should a lender consider in evaluating real
estate loan applications?
8. What options does a loan officer have in pricing consumer
loans?
9. What is home equity lending, and what are its advantages
and disadvantages for banks and other consumer lending
institutions?
10. Problem 2, 7, 9 and 13 (page 627-9)
142
Page 71
Answers
1. What special problems does business lending present to
the management of a business lending institution?
Though business loans are usually considered among the
safest types of lending (low default rate), these loans:
➢ average much larger in dollar volume than other loans
→ excessive risk of loss and, if a substantial number of
loans fail, can lead to failure
➢ business loans are usually much more complex financial
deals than most other kinds of loans, requiring larger
numbers of personnel with special skills and knowledge.
→ increase the magnitude of potential losses unless the
business loan portfolio is managed with great care & skill.
143
Answers
acquisition loans?
a. Working Capital Loans -- Loans to fund the current
assets of a business, such as accounts receivable,
inventories, or to replenish cash.
b. Open Credit Lines -- A credit agreement allowing a

business to borrow up to a specified maximum amount of
credit at any time until the point in time when the credit line
expires.
144
Page 72
Answers
acquisition loans?
c. Asset-based Loans -- Credit secured by the shorter-term
assets of a firm that are expected to roll over into cash in
the future. Credit whose amount and timing is based
directly upon the value, condition, and maturity of certain
assets held by a business firm (such as accounts
receivable or inventory) with those assets usually being
pledged as collateral behind the loan.
145
Answers
acquisition loans?
d. Term Loans -- Business loans that have an original

maturity of more than one year and normally are used to
fund the purchase of new plant and equipment or to
provide for a permanent increase in working capital. Term
loans usually look to the flow of future earnings of a
business firm to amortize and retire the credit.
146
Page 73
Answers
acquisition loans?
e. Revolving Credit Lines -- Lines of credit that promise the
business borrower access to any amount of borrowed
funds up to a specified maximum amount; the customer
may borrow, repay, and borrow again any number of times
until the credit line reaches its maturity date.
f. Interim Financing -- Bank funding to start construction or
to complete construction of a business project in the form
of a short-term loan; once the project is completed, long-
term funding will normally pay off and replace the interim
financing.
147
Answers
acquisition loans?
g. Project Loans -- Credit to support the start up of a new
business project, such as the construction of an offshore
drilling platform or the installation of a new warehouse or
assembly line; often such loans are secured by the
property or equipment that are part of the new project.
h. Acquisition Loans--Loans to finance mergers and

acquisitions of businesses. Among the most noteworthy of
these acquisition credits are leveraged buyouts of firms by
small groups of investors.
148
Page 74
Answers
Contingent liabilities include:
➢ Pending or possible future obligations as lawsuits against a
business firm, and warranties or guarantees the firm has
given to others regarding the quality, safety, or
performance of its product or service.
➢ A credit guaranty in which the firm may have pledged its
assets or credit to back up the borrowings of another
business, such as a subsidiary.
➢ Environmental damage caused by a business borrower
also has recently become of great concern as a contingent
liability for many banks
149
Answers
Loan officers must be aware of all contingent

liabilities because any or all of them could become
due and payable claims against the business
borrower, weakening the firm's ability to repay its
loan to the bank.
150
Page 75
Answers
a. Cost plus pricing is the simplest loan pricing model.

However, it assumes that a lending institution can
accurately know what its costs are and often they don’t.
b. Price leadership overcomes the problems of accurately

predicting what the costs of a loan will be to a lending
institution. However, it is still difficult to assign risk
premiums to loans. In addition, using something like the
prime rate as the base rate has been challenged by LIBOR
and other market based rates.
151
Answers
c. Below prime market pricing uses LIBOR as the base rate

and includes only a small profit margin as part of the loan
price. This works well for short term loans for large, well
known corporations but is not generally used for small and
medium sized companies or longer term loans
d. Customer profitability analysis is similar to cost plus
pricing but differs in that it considers the whole customer
relationship into account when pricing a loan. Customer
profitability analysis has become increasingly sophisticated
as computer models have been designed to help with the
analysis.
152
Page 76
Answers
5. Problem 3 (page 586)
Expense Control Ratios Operating Efficiency Measures
Wages and salaries / Net Sales Inventory turnover ratio
Overhead expenses / Net Sales Net sales / Total assets
Depreciation expenses / Net Sales Net sales / Fixed assets
Interest expense / Net Sales Net sales / Accounts receivable
Cost of goods sold / Net Sales Average collection period
Taxes / Net Sales
Selling, administrative & other
expenses / Net Sales
Coverage Ratios Marketability Indicators

Interest coverage GPM
Coverage of principal and interest NPM
payments
153
Answers
Profitability Measures Liquidity Indicators
Before-tax net income / Total assets Current ratio
After-tax net income / Total assets Acid-test ratio
Before-tax net income / Net worth Net liquid assets
or equity capital
After-tax net income / Net worth or Net working capital

equity capital
Before-tax net income / Net Sales Leverage Ratios

After-tax net income / Net Sales Total liabilities / Total assets
Long-term debt / Long-term
liabilities
Total liabilities / Net Sales
154
Page 77
Answers
The Sources and Uses of Funds Statement for Grape
Corporation would appear as follows:
Cash Flows from Operations
Net income 210
+ Depreciation 100
- increase in acc/rec (192)
- increase in inventory (79)
- increase in other assets (21)
+ increase in accounts payable 99
- decrease in taxes payable (111)
Net cash flow from operations 6
155
Answers
Cash Flows from Investment Activities

Acquisition of fixed assets (300)
Net cash flow from investment activities (300)
Cash Flows from Financing Activities

Increase in notes payable 197
Increase in long term debt 59
Dividends paid (50)
Net Cash Flows from Financing Activities 206
Increase (Decrease) in Cash -88
156
Page 78
Answers
There are several areas of possible concern for a bank
loan officer viewing Grape's projected figures. First, the
firm is relying heavily upon increasing debt of all kinds to
finance its growth in assets. The increase in notes payable
of $197 million indicates growing reliance on bank debt
supplemented by sizable increases in supplier-provided
credit (accounts payable) and long-term debt obligations
(most likely, bonds) with no change in funds provided by
issuing stock. The bank could experience a serious
weakening in the strength of its claim against the firm as
other creditors post a more substantial claim against
Grape’s assets.
157
Answers
Grape is projecting a sizable increase in its retained
earnings (undivided profits) which suggests that
management is counting on a year of strong earnings.
However, both accounts receivable and inventories (as
well as net fixed assets) are growing rapidly, perhaps
reflecting troubles in collecting from the firm's customers
and in marketing Grape's products and services. The
bank's loan officer would want to explore with the company
the bases for its projected jump in net income and why
accounts receivable and inventories are expected to rise in
such large amounts
158
Page 79
Answers
The total of expected revenues and expected costs is:
Expected Revenues Expected Costs
Interest Revenue $400,000 Deposit Interest $

74,375
Commitment Fees 100,000 Cost of Other Funds 180,000
Raised
Deposit Service 4,500 Wire Transfer Costs 1,300

(Maintenance) Fees Loan Processing Costs 12,400
Wire Transfer Fees 3,500 Record keeping 4,500
Expenses
Agency Fees 4,500 Account Activity Cost 5,000
Total Expected $512,500 Total Expected Costs $ 277,575
Revenues
159
Answers
Net revenue = $512,500 - $277,575 = $234,925

Net funds loaned = $10,000,000 - $2,125,000 = $7,875,000
Expected net rate of return

= $$234,925/ $7,875,000 = 0.0298 or 2.98%
Because the estimated net rate of return is positive, the bank

should strongly consider approving the loan as requested
because the bank can earn a premium over its costs.
160
Page 80
Answers
If you decide to turn down this request, under what
assumptions regarding revenues, expenses, and
customer-maintained deposit balances would you make
this loan?
a. raise the interest rate on the loan
b. increase the loan commitment fee
→ Depending on the customer's relationship with the bank
and with other banks, this may prove to be extremely
difficult.
161
Answers
this loan?
c. Allow the borrower to borrow less than the full amount
($10mil), the cost of funds raised to support this loan
could be reduced → increase the loan net revenue
d. Make some adjustment in the expenses associated with
the relationship, (e.g. a careful examination of the
relationship activities could allow for a revision of
estimated costs incurred by the bank to manage the
various aspects of the relationship).
162
Page 81
Answers
this loan?
e. Raise customer-maintained balances, making the net

funds loaned smaller and the expected net rate of return
greater.
163
Answers
Lone Star Bank has sold negotiable CDs in the amount of $6

million at a yield of 2.75% and purchased $4 million in
federal funds at a rate of 2.80%. The weighted average
cost of bank funds in this case would be:
$ 6,000,000 * .0275 = $165,000

$ 4,000,000 * .0280 = $112,000
Total Interest Cost = $277,000
164
Page 82
Answers
On a $10 million loan this is an average annual interest cost of
$277,000/$10,000,000 or 0.0277 which is 2.77%. There was
also $25,000 in noninterest costs or 0.25% of the loan total of
$10 million. With a one percent risk premium and a 0.25%
minimal profit margin, the loan rate on a cost-plus basis would
be:
Interest Cost + Non-interest Cost + Risk Premium + Profit Margin
= 2.77% + 0.25% + 1.00% + 0.25% = 4.27%.
To break even we take out the profit margin, thus the loan rate
would be: 4.27 -.25 = 4.02%
Interest Cost = Loan rate - Non-interest cost - Risk premium
Interest cost = 4.27 – 0.25 – 1.00 = 3.02%
165
Answers
6. How do credit-scoring systems work?
Credit-scoring systems use statistical techniques

(usually multiple discriminant analysis) to classify
borrowers based on selected characteristics of each
borrower as to whether they are likely or unlikely to repay
the loan they have requested.
166
Page 83
Answers
6. How do credit-scoring systems work?
Credit-scoring systems are usually based on discriminant

models or related techniques, such as logit or probit
analysis or neural networks, in which several variables are
used jointly to establish a numerical score for each credit
applicant. If the applicant’s score exceeds a critical cutoff
level, he or she is likely to be approved for credit in the
absence of other damaging information. If the applicant’s
score falls below the cutoff level, credit is likely to be
denied in the absence of mitigating factors.
167
Answers
6. What are the principal advantages & disadvantages to a
lending institution of using a credit-scoring system?
Adv: The credit scoring method has the advantage of being
objective, requiring less loan officer judgment, possibly
lowering loan losses, and lowering operating costs when a
large volume of consumer loans is processed.
Disadv: Credit scoring systems do not take into account

motivational factors or individual differences and may
become outdated unless frequently retested for statistical
accuracy.
168
Page 84
Answers
7. What factors should a lender consider in evaluating real
estate loan applications?
a. What is the borrower's monthly income and monthly debt

repayments? The bank must be assured there is adequate
cushion to comfortably absorb the home loan repayments.
b. Does the borrower have good prospects for continued
employment? Because the loan is long term the bank
must have reasonable assurance the borrower can service
a long-term loan.
c. Is the current market value of the home to be purchased
sufficiently larger than the amount of the loan to give the
bank adequate cushion if local real estate values decline?
169
Answers
8. What options does a loan officer have in pricing consumer
loans?
Most consumer loans, like most business loans, are

priced off some base or cost rate, with a profit margin and
compensation for risk added on. The rate on a consumer
loan may be figured from the cost-plus model or the base-
rate model. Most installments and lump-sum payment
loans are made with fixed interest rates. However, due to
the volatility of interest rates in the 1970’s and 1980's, a
greater number of floating rate consumer loans have
appeared.
170
Page 85
Answers
9. What is home equity lending, and what are its advantages
and disadvantages for banks and other consumer lending
institutions?
Home-equity loans use the residual market value of a home
(over and above the amount of any outstanding liens against
the home) as a borrowing base. Financial institutions often
lend a fraction of this residual value, which subjects them to
the risk that the market value of a home will fall, significantly
eroding the cushion of protection for a loan of this type. If the
customer fails to make any promised loan payments, the bank
or other lender could foreclose and take over the home to sell
it and recover at least a portion of loaned funds.
171
Answers
The maximum credit line available is:
$110,000 x 0.70 - $60,000 = $77,000 - $60,000 = $17,000.
This would clearly not result in a large enough borrowing

base to cover the $24,000 loan requested. Many banks
make adjustments in the permissible loan amount if the
customer has an above-average level of income, other
assets to pledge, relatively low mortgage debt obligations,
and an excellent credit rating. Thus, the Nappers may be
able to qualify for an additional $17,000 in loanable funds
(perhaps by pledging other collateral) to make up the
$24,000 they need.
172
Page 86
Answers
The total loss to the bank from delinquent customers is
$47.523 million or 7,665 customers * $6,200. On the other
hand, paying credit-card customers (amounting to 3,066
customers) averaged a score of 40 points or less, but
successfully generated about $1,000 a piece in revenues,
resulting in aggregate revenues of $3.066 million or $1,000
* 3,066 customers. By adopting a decision rule to grant
credit-card privileges only to customers scoring more than
40 points (and assuming about the same average
revenues and losses) the bank will save about $44.457
million.
173
Answers
10. Problem 9 (page 628-9)
The credit scoring system considers the following factors:
Length of employment: > 1 year –6 points
Length of time at current address: 1-2 years – 4 points
Current home situation: rents home – 4 points
Credit bureau report: excellent – 8 points
Credit cards currently active: 2 cards – 4 points
Deposit accounts with bank: Yes – 5 points
Total 31 points
The Mulvaney family has a point total of 31. San Carlos Bank
and Trust has a cutoff score of 30 points so the Mulvaneys
are likely to receive their loan.
174
Page 87
Answers
Interest paid = Loan principal * Loan rate
= $8,000 * 0.0575 = $460
What is the amount of each required monthly payment?
Amount of monthly payment = ($8,000 + $ 460) / 12 = $705
What is the effective loan rate in this case?
Effective loan rate = Interest owned/Average loan amount

= 460 / 4,000 = 11.5%
175
LENDING TO BUSINESSES AND

CONSUMERS
Chapter 4
176
Page 88

Bank Lending to Businesses and Consumers Guide

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Bank Lending to Businesses and Consumers Guide

Uploaded by

Copyright:

Available Formats

LENDING TO BUSINESSES AND

◼ A banker is a fellow who lends his

Types of loans made by banks

◼ Real estate loans

◼ Commercial and industrial loans

◼ Financial institution loans

◼ Lease financing receivables

Loans Outstanding for U.S. Banks (2007)

Factors determining the mix of bank loans

▪ Characteristics of market area: most lenders are

▪ Lender size: legal lending limit to single borrower.

➢ Smaller banks → retail credit

Factors determining the mix of bank loans (cont.)

◼ Criticized loans: performing well but lender

◼ Scheduled loans: containing significant

◼ Adversely classified loans: carrying risk of not

➢ Doubtful loans: carrying a strong probability of loss

➢ Loss loans: uncollectible or unsuitable to be called

Regulators’ use of market forces

Because the quality of examination information

Establishing a Good Written Loan 16-12

Bank’s Written Loan Policy (cont.)

7. Guidelines for taking and perfecting collateral

Steps in the lending process

Short term business loans

1. Self-liquidating inventory loans:

▪ used to finance the purchase of inventory, taking

the advantage of cash cycle in a business firm

▪ Demand for traditional inventory loans is on the

decline due to the development of the JIT (just in

time) and supply chain management techniques

Self-liquidating inventory loans:

1. Cash is spent to acquire inventory

2. Goods are produced or shelved and listed for

3. Sales are made (often on credit)

4. The cash received is used to repay the self-

Short term business loans

2. Working capital loans: closest to self-liquidating loans

Short term business loans

3. Interim construction loans: support the construction

▪ Fund supplied to hire workers, lease construction

▪ The loan is paid off with a longer-term mortgage loan

▪ “Mini-permanent loan” providing fund for the construction

Short term business loans

Short term business loans

Short term business loans

Short term business loans

Long-term business loans

Revolving credit lines

Project loans (cont.)

▪ Project loan may be granted on

▪ Non-recourse basis: no sponsor guarantees, project

Loans to support firm acquisitions

▪ Loans to finance mergers/acquisitions of businesses

▪ Most noted: LBOs (leveraged buyouts)

▪ Firm purchased is financed heavily by debt in the

▪ Frequently optimistic assumptions have turned to be

1. How business loans are classified in Vietnam?

2. What are the essential differences between

various short- and long-term business loans?

3. What special problems does business lending

Loan types (Circular 39/2016/TT-NHNN)