Chapter 7

“Neither a borrower now a lender be; For loan oft
loses itself and a friend, and borrowing dulls the

edge of husbandry.”
William Shakespeare
Contemporary Financial
Intermediation
Chapter 7.
Spot Lending
Key Questions
• What assets does a bank have on its balance sheet?
• What is lending? What is a loan?
• What is a security? What is the difference between a

loan and a security?
• How is a loan agreement typically structured?
• What are the main informational problems in loan

contracts? How do we solve them?
• Why and how does a bank do credit analysis?
• Why is collateral so widely used?
• Why and what kinds of covenants are used in loan

contracts?
Contemporary Financial Intermediation

2
Stuart I. Greenbaum, Anjan V. Thakor, and Arnoud W. A. Boot
What assets does a bank
have on its balance sheet?:
Bank Assets
• Three basic types of assets on a
bank’s balance sheet: loans,
marketable securities, and cash
Bank Assets
Loans Securities Cash
C&I Consumer

3
Composition of
Commercial Bank Assets
• Loans: have declined slightly over time as
percentage of total assets
• Security holdings: declined slightly in the
late 1970s, relatively steady since
• Cash and reserves: declined consistently
through time
• Other assets have grown
100%
90%
80%
Loans
70%
60%
50%
40%
30%
20% Securities and Corporate Bonds
10%
Other Assets
0% Cash and Reserves
1975 1980 1985 1990 1995 2000 2005 2010

4
Composition of
Commercial Bank loans
• C&I loans: have declined in relative importance
as banks have increased mortgage holdings
– Relative advantage of banks over the capital market
in providing credit to (large) firms has diminished
• Consumer credit: declined slightly from 20% in
1975 to 15% in 2004, but has grown since then.
100%
90%
C & I Loans
80%
70%
60%
Consumer credit
50%
40%
30% Mortgages
20%
10%
0% Open Market Paper and Security Credit

1975 1980 1985 1990 1995 2000 2005 2010

5
Types of Bank Loans
– C & I Loans
• Transaction loans
– Negotiated for specific transactions and tailored
to the needs of the borrower
– Episodic demand from a particular borrower
– Usually secured by assets financed with the
loan
• Working capital loans
– Used to finance routine day-to-day transactions
– General purpose, short-term borrowing
– Usually secured by accounts receivables and
inventories
• Term loans
– Longer maturity (3-10 years) loans used to buy
fixed assets
– Repayment normally amortized
– Revolving lines of credit or similar commitment
• Combinations
– Working capital loans that permit the
conversion into terms loans

6
Types of Bank Loans
– Consumer loans
• Consumer loans (excluding mortgages)
– Direct consumer loans
• Made for financing purchases of durable goods
and secured with the asset being purchased
– Credit cards
• Short-term, unsecured general purpose credit
• Became widely used in the mid-1960s
• Very profitable for banks (2-6% discount from
merchants, APR to card users, annual
membership fees)
• Mortgage loans
– For acquisition or improvement of real estate
– secured by the real estate they finance
– Securitization has improved liquidity
– Explosion in the variety of mortgage designs

7
Commercial Bank Loans

8
Marketable Securities
• Bankers acceptances
– Arise when a bank accepts a time draft written by a
firm; the bank can either hold it or sell it in the
secondary market
– Maturity usually less than 6 months
– Facilitate international trade
• Commercial Paper
– Unsecured debt issued on the strength of the issuer’s
name with maturity 3-370 days
– Issued only by best-known firms
• U.S. government securities
– Default-free nature and highly liquid markets
– T-bills , T-notes, and T-bonds
• U.S. government agency securities
– Certificates of indebtedness issued by U.S.
government agencies, e.g., Fannie Mae, FHLB,
Ginnie Mae
• State and local securities and municipal bonds
– Three categories: housing authority bonds, general
obligation bonds, and revenue bonds
• Other assets

9
What Is Lending?
• What is a bank loan?

– Definition: it is the purchase of an asset (the
borrower’s indebtedness) that is typically
illiquid and highly customized financial claim
again the borrower’s future cash flows
• How do banks acquire loans?

– Spot market purchases
• Originate loans and then fund them by keeping
them on their own books
• Purchase loans originated by other
intermediaries
– Forward market purchases
• Loan commitment: a promise to lend in the
future on pre-specified terms
– Spot and forward lending are interdependent

10
Decomposition of
the Lending Function
•Solicitation of customer’s
business.
•Loan application.
ORIGINATION •Credit analysis.
•Design of loan contract
including pricing.
•Loan extension conditional

on affirmative outcome of
FUNDING credit analysis.
•Bookkeeping.
SERVICING •Collection of loan payments.
LENDING
•Post-lending monitoring to
control default risk.
•Diversification to control
default risk.
RISK
•Loan workouts to control
PROCESSING default risk.
•Control of interest rate risk.
•Organizational design.
•Reporting arrangements.
CREDIT •Communication practices.
CULTURE •Incentive schemes for credit
officers.
11
What is a security? What
is the difference between
a loan and a security?
• Typically viewed as two distinct claims,
loan and securities are really quite similar
• Except that the latter are usually more

liquid:
– Securities are traded in secondary market and
loans as private debt placement with banks are
usually not
– Interrelated liquidity and marketability
• Erosion of the distinction between loans

and securities
– Loan sales: outright sale or loan syndication
– Securitization

12
How is a loan-agreement
typically structured?
• A loan agreement (1) specifies the
obligations of borrower and lender,
(2) makes certain warranties, and (3)
usually places certain controls and
restrictions on the borrower.
• Details:
– Principal (amount to be borrowed)
– Maturity (short-, intermediate-, long-term)
– Pricing formula (fixed/floating rate,
transaction rate, closing fee, etc.)
– Provisions (conditions precedent,
warranties, covenant and events of default)

13
Standard Provisions
• Conditions precedent
– Requirements the borrower must satisfy before the
bank is legally obliged to fund the loan
– Examples: business transactions that must be
completed or evens that must have occurred,
opinions of counsel, certificate of no defaults,
resolutions of the borrower’s board of directors
authorizing the transaction
• Warranties
– Information and assumptions about the borrower’s
legal status and creditworthiness
– Examples: warranties that all financial statements
submitted are genuine and fairly represent the
borrower’s financial position, that borrower has a
valid title of all assets, that borrower has complied
with all federal, state, and municipal laws and is not
involved in litigation, etc.
• Covenants
– Minimum standards for the borrower’s future
conduct and performance

14
What are the Main
Informational Problems
in Loan Contracts?
Pre-contract Post-lending
Private Information Moral Hazard
Credit
Asset Effort
Analysis
Substitution Aversion
Loan Contract
Design and
Monitoring

15
Loan Performance
• Importance of loan performance:

– A bank’s loan portfolio affects its financial health
and viability
– Loan losses also spell trouble for top management at
the bank
• Loan portfolio diversification

– Benefits have begun to strongly influence bank’s
portfolio choices in the 1990s and post-2000
– Coincides with the growing popularity of loan
syndication, loan sales and securitization
• Why are banks not highly diversified?

– Limitations on the opportunity to diversify
– Forgoing a loan may be costly
– Constrained by regulations that mandate serving
specific communities
– Specialization induced by cross-sectional reusability
of information

16
Why and How does a
bank do credit analysis?
• Objective: to determine the ability and
willingness of the borrower to repay the
loan
• How to do credit analysis?

– Examine factors that may lead to default in the
repayment of a loan
– Look at the borrower’s past record (reputation)
as well as its economic prospects
– Look at the present economic condition and
forecast future cash flows
• Must remember:
– It is the bank, not the borrower, that owns the
asset being financed (call option for borrower)
– Getting unwilling borrower to repay the loan in
today’s legal environment is not easy

17
Credit Analysis: Five Cs
Capacity:
Ensures that borrower has legal and
economic capacity to borrow.
Character:
Refers to borrower’s reputation and hence
desire to settle debt obligations.
Capital: Borrower’s
Resolves private information and moral Repayment
hazard problems. Likelihood
Collateral:
Includes both “inside” and “outside”
collateral. These resolve private information
and moral hazard problem. Also directly
reduces bank’s risk. Moreover, collateral can
eliminate underinvestment problem.
Conditions:
These are economic conditions that affect
borrower’s ability to repay the loan.

18
Capacity
• Legal capacity to borrow:

– In the case of partnerships, important to
know whether all the signing partners have
the legal authority to borrow
– In the case of corporation, need to check
the corporate charter and bylaws to
determine who has the authority to borrow
• Financial capacity to borrow:

– Evaluating borrowers’ future cash flows
available to service the debt
– May demand that the borrower subordinate
the claims of others

19
Character
• Borrower’s ability to repay debts

and desire to settle all obligations
within the terms of the contract
• Requires a careful examination of

the borrower’s past record in debt
repayment and related behaviors
– The better a borrower’s credit reputation,
the less incentive it has to default

20
Capital
• Equity capital (as a fraction of total assets)

the borrower has invested in the firm
• Helps to resolve moral hazard by imposing

a greater loss on the borrower for poor
project outcomes (Example 5.1)
– With capital, borrower’s cost of pursuing risk is
increased and the call option value is decreased
• Signals the profitability of the borrower’s

project and the confidence in the firm’s
future prospects (Example 5.2)
• Interest rate inversely related to the

borrower’s equity-to-total-assets ratio

21
Collateral
• Lender has first claim to collateral in the

event of default
• Inside collateral: assets owned by the firm

to which the loan is extended, e.g.,
accounts receivables, equipment,
machinery, real estate, and inventory
• Outside collateral: assets that the bank

would never have a claim to unless they
were specifically designated as collateral,
e.g., personal assets of the owner with
limited liability
• Costs of using collateral:

– Ongoing monitoring of the collateral
– Liquidation costs, including legal costs of
ownership transfer, costs of carrying and selling

22
Why Is Collateral So
Widely Used?
• Risk reduction
– Collateral provides the lender greater
protection against loss in the event of
default
• Signaling instrument
– Collateral can convey valuable information
to the bank (Example 5.3)
• Moral hazard
– Using collateral can help resolve a variety
of moral hazard problems:
• Asset substitution (Example 5.4)
• Underinvestment (Example 5.5)
• Inadequate effort supply (Example 5.6)

23
Condition
• Economic conditions that affect the

borrower’s ability to repay the loan:
– Income
– Sale of assets
– Sale of stock
– Borrowing from another source
• Borrower’s ability to generate income

depends on:
– Selling prices of its goods
– Costs of inputs
– Competition
– Quality of goods and services
– Advertising effectiveness
– Quality of management
• Need analysis of borrower’s financial

statements as well as its management

24
Trends in Credit Analysis
• Banks are becoming increasingly sophisticated
in credit analysis
• Rely more on computer-based statistical

analysis of borrower attributes to determine the
level of risk inherent in a particular loan
– Discriminant analysis
– Neural network and “expert systems”
– Irony: The more banks rely on such models, the
lower is the importance of “soft information” about
the borrower- information that is not amenable for
quantification and statistical analysis- and hence the
smaller is the competitive advantage of the bank
over other lenders.
• Key shortcoming of computerized credit

scoring models:
– Models are based on data drawn solely from
extended loans  selection bias
25
Sources of
Credit Information
• Credit information:
– Costly and of uneven quality
– Needs to be used cleverly by banks
• Internal sources:
– Interview with applicant
– Bank’s own records
• External sources:
– Borrower’s financial statements
– Credit information brokers
• Dun & Bradstreet (D&B)
• Robert Morris Associates
– Other banks
– Borrower’s suppliers and customers

26
Analysis of
Financial Statements
• Firm’s internal sources for future
generation of funds:
– Net income
– Depreciation
– Reduction of accounts receivables
– Reduction of inventories
• Financial statements convey noisy

information about the potential of these
cash flows
– Audited statements: months too old,
idiosyncracies of GAAP, occasional lapses and
professional compromises of auditors
– Unaudited interim statements: raise questions
of authenticity
– Assets valued using non-market criteria such as
book values  income distorted
– Should be interpreted with caution
27
Balance Sheet – Assets
• Accounts Receivables
– Among the shortest maturity assets
– Major source of repayment for short-term loans
– Analyses focus on sizes, sources, and aging of
accounts, as well as how actively they are managed
and diversified
• Contract Receivables
– Arise when borrower has received contract to
perform future task
– Borrower’s customer recognizes his (potential) debt
obligation officially in chattel paper
– Riskier than accounts receivables because of double
moral hazard, thus need greater monitoring efforts
• Inventory
– Issues including age, liquidity, price stability,
obsolescence, shrinkage, adequacy of insurance
coverage, stage of processing, and method of
inventory accounting

28
Balance Sheet – Assets
• Fixed Assets
– Key is their ability to produce cash flows and
not their resale value
– Surplus fixed assets (generated by business
restructuring) can be occasional and strategic
sources of cash flows
• Intangible Assets
– Trademarks, patents, copyrights, and goodwill
– Normally accorded little value because of
illiquidity and measurement errors
– Large discounts often applied to such assets
• Amounts Due
– Create suspicion of internal fraud and nepotism
– Thus banks often take a dim view of a firm’s
management if assets include amounts due from
officers and employees

29
Balance Sheet –
Liabilities and Net Worth
• Accounts Payable
– Payable in the form of notes may indicate firm has
been denied trade credit
– Be alarmed if suppliers insist on COD terms
– Notes payable to managers should be subordinated to
bank loans
• Long-Term Liabilities
– Term loans, debentures, notes, mortgages, other
liabilities with maturities exceeding 1 year
– Examine when these are due and what assets have
been used to secure them
• Net Worth
– Accounting net worth is a treacherous account
because of measurement errors
• Contingent Liabilities
– Potential to become actual liabilities
– Assessing probabilities and exposure is critical
– Footnote disclosures

30
Income Statement
• Balance sheet
– Statement of stocks
– Emphasized in evaluating short-term loans
• Income statement
– Statement of flows
– Emphasized for longer-maturity loans
– Degree of stability in borrower’s cash flows
• Financial ratios
– Convey information about liquidity, stability,
profitability and cash flow prospects
– Usually expressed in terms of accounting
values: higher distortions

31
Ratio Analysis
• Liquidity ratios
– Current ratio = current assets / current liabilities
– Quick ratio (acid test ratio) = (current assets –
inventories) / current liabilities
• Activity ratios
– Inventory turnover ratio = sales / inventory
– Average collection period (in days) = receivables /
sales per day
– Total assets turnover = sales / total assets
– Fixed assets turnover = sales / net fixed assets
• Profitability ratios
– Profit margin on sales = net profit after taxes / sales
– Return on total assets = net profit after taxes / total
assets
– Return on net worth = net profit after taxes / net
worth
• Leverage ratio
– Leverage ratio = total debt / total assets

32
Why and What kinds of
Loan Covenants are
used?
• Special clauses designed to protect the
bank and prohibit borrower from taking
actions that could adversely affect the
likelihood of repayment
• Reduce moral hazard faced by lender and

improve the terms of the loan agreement
for borrower
• Make possible loans that would not

otherwise be made at all
• May deprive the borrower of valuable

investment options and strategies
• Depend on borrower’s financial condition,

track record of its management, and the
bank’s lending philosophy

33
Loan Covenants
• Affirmative covenants
– Obligations imposed on the borrower
– Examples: provision of periodic financial
statements, maintenance of minimum working
capital, management acceptable to the bank
• Restrictive clauses
– Limits on the borrower’s actions
– Examples: restrictions on dividends, salaries,
bonuses, investments (e.g. purchases of fixed assets)
• Negative covenants
– Prohibitions on the borrower
– Examples: negative pledge clause, prohibitions on
mergers, consolidations, and sales of assets
• Default provisions
– Conditions under which the entire loan is made
immediately due and payable
– Acceleration clause that specifies events of default

34
Conclusion
• A loan typically is an illiquid debt contract,

without an active secondary market.
• Bank loans usually have less known about

them than corporate bonds.
• Banks are expected to lend to borrowers

about whom less is known a priori and for
whom moral hazard is a concern.
• Collateral and capital play an important role

in overcoming informational problems in
traditional credit analysis.
• The bank’s lending decision is a complex

one and expertise in credit analysis, loan
contract design, and post-lending
monitoring is a valuable resource.

35

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Chapter 7

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“Neither a borrower now a lender be; For loan oft

loses itself and a friend, and borrowing dulls the

• What is lending? What is a loan?

• What is a security? What is the difference between a

• How is a loan agreement typically structured?

• What are the main informational problems in loan

• Why and how does a bank do credit analysis?

• Why is collateral so widely used?

• Why and what kinds of covenants are used in loan

Contemporary Financial Intermediation

Loans Securities Cash

Contemporary Financial Intermediation

20% Securities and Corporate Bonds

Contemporary Financial Intermediation

0% Open Market Paper and Security Credit

Contemporary Financial Intermediation

Contemporary Financial Intermediation

Contemporary Financial Intermediation

Contemporary Financial Intermediation

Contemporary Financial Intermediation

• What is a bank loan?

• How do banks acquire loans?

Contemporary Financial Intermediation

•Loan extension conditional

• Except that the latter are usually more

• Erosion of the distinction between loans

Contemporary Financial Intermediation

Contemporary Financial Intermediation

Contemporary Financial Intermediation

Contemporary Financial Intermediation

• Importance of loan performance:

• Loan portfolio diversification

• Why are banks not highly diversified?

Contemporary Financial Intermediation

• How to do credit analysis?

Contemporary Financial Intermediation

Contemporary Financial Intermediation

• Legal capacity to borrow:

• Financial capacity to borrow:

Contemporary Financial Intermediation

• Borrower’s ability to repay debts

• Requires a careful examination of

Contemporary Financial Intermediation

• Equity capital (as a fraction of total assets)

• Helps to resolve moral hazard by imposing

• Signals the profitability of the borrower’s

• Interest rate inversely related to the

Contemporary Financial Intermediation

• Lender has first claim to collateral in the

• Inside collateral: assets owned by the firm

• Outside collateral: assets that the bank

• Costs of using collateral:

Contemporary Financial Intermediation

Contemporary Financial Intermediation

• Economic conditions that affect the

• Borrower’s ability to generate income

• Need analysis of borrower’s financial

Contemporary Financial Intermediation

• Rely more on computer-based statistical

• Key shortcoming of computerized credit

Contemporary Financial Intermediation

• Financial statements convey noisy

Contemporary Financial Intermediation