CHAPTER 1

THE PRINCIPLES OF LENDING

AND LENDING BASICS
Learning objectives
 Identify the basic principles governing bank lending and explain
their importance
 Understand the framework within which credit and lending
decisions are taken
 Understand the Credit Process
 Explain the characteristics of various types of bank advance
 Distinguish different types of borrowers and the special
considerations that apply to them when giving loans
 Explain how advances are structured
 Explain the importance of credit culture in a lending institution
 Understand how an advance portfolio is designed
 The principles of good lending
 Safety of Loan:
This principle requires that a loan is granted to only that borrower who is
considered safe, i.e. a one who is of good character
 Suitability of loan
Loans must be given for any valid purpose, i.e. a one that is legal and conforms
to the lending policy of the bank

 Profitability
Banks are in the business of lending to earn profits, so they will compare the
cost and benefit of a loan before granting a loan.

 Following the lending principles – Credit analysis

Credit analysis can be done by traditional or modern methods
Traditional methods of credit analysis

 Any credit analysis is concerned with the

measurement of credit risk. The traditional method
of assessment is done using the following criteria
known as the 5 Cs:
1- Character
2- Capacity
3- Capital
4- Collateral
5- Conditions
Traditional methods of credit analysis
Five key questions/issues:
1. What is the character of the borrower and the
quality of information provided?
2. What are the loan proceeds going to be used for?
3. How much does the customer need to borrow?
4. What is the primary source of repayment and
when?
5. What collateral is available ?
(Secondary source of repayment)
Traditional methods of credit analysis

The 5Cs:
 Character: It involves collecting information about the borrower’s track record of
integrity, repayment ability and spending habits, i.e. what is the trust worthiness of
the borrower
 Capacity: is the ability to repay the loan together with interest as per the pre-
determined schedule (this is the financial capacity).
 Capital: It refers to the capital contribution that the borrower proposes to make in
the total investment (this establishes the owner’s stake in the project and therefore,
the higher the owner’s stake the more confident the lender is)
 Collateral: Also known as the secondary source of repayment. It is a sort of a
guarantee (security that the lender takes possession of and use it in case of default)
 Condition: The analysis of condition covers external and internal factors. The
external conditions include the condition of the economy, the relevant industry, etc.
The internal conditions include, lending policies, budget, staff, etc.
Modern approaches to credit analysis

The more commonly used modern approaches include the

following:
 Econometric techniques – involves the modeling of the
probability of default
 Optimization models – use mathematical programming
techniques to minimize lender errors and thus maximize
profits
 Neural networks – try to emulate the human decision making
process using data as used in econometric techniques.
 Hybrid systems – Involves establishing causal relationships
by estimating parameters of such relationships.
A Framework for credit and lending
Process
General Law of the Land

Lending Policy
Strategic Considerations

Loan Portfolio Design

Uniform Consumer

5 Cs of lending

Consumer Act
Reserve Act
Credit Code

Borrower
Specific Factors

Internal Factors

External Factors
External Factors
 General Law of the Land: Institutions cannot lend for an unlawful
activity (Cannot lend for illegal purpose)
 Macroeconomic factors: The conditions of the economy affects the
lending decisions.
 Industry-specific factors: While the economy may be in good shape, a
particular industry may be in trouble, so firms must take particular care
with a loan for firms in that industry.
 The reserve bank act and the banking act: Central banks have the power
to step and issue suitable directions to regulate the reserves and other
various provisions that have impacts on the lending decisions.
 Uniform Consumer Credit Code: Lending officers have to comply with
the provisions of the consumer credit code (will be explained in another
chapter)
 Lending institutions specific factors (internal
factors)

 The lending policy of the institution: All advances have to comply

with the lending policy of the lending institution
 The loan budget: lending firms have a lending budget which they
must observe, i.e. in case fund shortages they may restrict lending
 Staff availability: Lending institutions may restrict the lending if
they are shortage of skilled staff who will appraise and monitor
loans
 Once a loan request satisfies the requirements of the various issues
related to the external and internal factors, then borrower specific
factors need to be considered.
Borrower Specific Factors
 They refer o the 5Cs
 The lending officer examines the character of the
prospective borrower from various sources
 The capital (owner’s stake in the proposed
investment) that the borrower is prepared to make
 The capacity to repay
 The conditions of the loan
 The collateral in case of non repayment of the loan
The Credit Process
Business Development and Credit
Analysis
 Market research
 Advertising, public relations
 Officer call programs
 Obtain formal loan request
 Obtain financial statements,
borrowing resolution, credit
reports
 Financial statement and cash
flow analysis
 Evaluate collateral
 Line officer makes
recommendation on
accepting/rejecting loan
Credit Execution and
Administration
 Loan committee reviews
proposal/recommendation
 Accept/reject decision made, terms
negotiated
 Loan agreement prepared with
collateral documentation
 Borrower signs agreement, turns
over collateral, receives loan
proceeds
 Perfect security interest
 File materials in credit file
 Process loan payments, obtain
periodic financial statements, call
on borrower
Credit Review
 Review loan documentation
 Monitor compliance with loan
agreement:
Positive and negative loan
covenants
Delinquencies in loan
payments
Discuss nature of delinquency or
other problems with borrower
 Institute corrective action:
Modify credit terms
Obtain additional capital,
collateral, guarantees
Call loan
The Credit Process
 Loan Policy
 Formalizes lending guidelines that employees follow
to conduct bank business
 Credit Philosophy
 Management’s philosophy that determines how much
risk the bank will take and in what form
 Credit Culture
 The fundamental principles that drive lending activity
and how management analyzes risk
The Credit Process

 Credit Culture
 The fundamental principles that drive lending activity
and how management analyzes risk
 Values Driven
 Focus is on credit quality
 Current-Profit Driven
 Focus is on short-term earnings
 Market-Share Driven
 Focus is on having the highest market share
Business Development and Credit Analysis

 Business Development
 Market research
 Train employees:
 On what products are available
 What products customers are likely to need
 How they should communicate with customers about those
needs
 Advertising and Public Relations
 Officer Call Programs
Business Development and Credit Analysis

 Credit Analysis
 Evaluate a borrower’s ability and willingness to repay
 Questions to address
 What risks are inherent in the operations of the business?
 What have managers done or failed to do in mitigating
those risks?
 How can a lender structure and control its own risks in
supplying funds?
Credit Execution and Administration

 Loan Decision
 Individual officer decision
 Committee
 Centralized underwriting
 Loan Agreement
 Formalizes the purpose of the loan
 Terms of the loan
 Repayment schedule
 Collateral required
 Any loan covenants
 States what conditions bring about a default
Credit Execution and Administration

 Documentation: Perfecting the Security Interest

 Perfected
 When the bank's claim is superior to that of other creditors
and the borrower
 Require the borrower to sign a security agreement that assigns
the qualifying collateral to the bank
 Bank obtains title to equipment or vehicles
Credit Execution and Administration

 Position Limits
 Maximum allowable credit exposures to any single
borrower, industry, or geographic local
 Risk Rating Loans
 Evaluating characteristics of the borrower and loan to
assess the likelihood of default and the amount of loss
in the event of default
Credit Execution and Administration

 Loan Covenants
 Positive (Affirmative)
 Indicate specific provisions to which the borrower must
adhere
 Negative
 Indicate financial limitations and prohibited events
Sample of Loan Covenants
Negative
 Capital outlays cannot exceed $3
million annually
 Cash dividends cannot exceed 60%
of periodic earnings
 Total officers' salaries cannot exceed
$500,000 annually
 No liens on assets beyond existing
liens
 No mergers, consolidations, or
acquisitions without bank approval
 No sale, lease, or transfer of more
than 10% of existing assets
 No change in senior management
 No additional debt without bank
approval
Affirmative
 Borrower must maintain following financial
ratios:
Current ratio >1.0
Days receivables outstanding <50 days
Inventory turnover >4.5 times
Debt to total assets <70%
Net worth >$1 million
Fixed charge coverage >1.3 times
Cash flow from operations >dividends
+ current maturities of long-term debt
 Certified financial statements must be provided
within 60 days of end of each fiscal year
 Borrower will maintain $500,000 key man life
insurance policy on company president, with bank
named as beneficiary
 Bank will be allowed to inspect inventory,
receivables, and property periodically
 Borrower must pay all taxes and government fees,
unless contested in good faith, and comply with
all laws
 Borrower must inform bank of any litigation or
claim that might materially affect its performance
 Borrower must maintain all property in good
condition and repair
Credit Review

 Loan Review
 Monitoring the performance of existing loans
 Handling problem loans
 Loan review should be kept separate from credit
analysis, execution, and administration
 The loan review committee should act independent of
loan officers and report directly to the CEO of the
bank
Credit Review

 Problem Loans
 Often require special treatment
 Modify terms of the loan agreement to increases the
probability of full repayment
 Modifications might include:
 Deferring interest and principal payments

 Lengthening maturities

 Liquidating unnecessary assets

Credit risk management strategy:
Credit risk is divided into two parts:
 Transaction risk – is the risk taken as bank accumulates

loans one at a time, it has 3 components:

 selection risk
 Underwriting risk

 Operational risk

 Portfolio risk is divided into:

 Intrinsic risk which arises from factors unique to specific
borrowers
 Concentration risk which arises from the proportion of the loans
accumulated in a single industry
Controlling Loan Losses
 Securing Collateral:
The bank takes a legal interest in borrower collateral to
gain the right to sell the collateral
(Most S.T. Loan to high borrowers are not secured, but
most L.T. loans are secured).
 Loan Review Function:
 Banks tries as much as possible not to make bad loans, but
some bad loans are bound to occur
 Some few losses are acceptable, because if they are not
accepted, the bank may turning down some good loans.
Characteristics of different types of advances

Advances can be classified into traditional and

modern types
Traditional types of advances

Loans: The entire loan is given to the borrower in one lump sum. The
loan (principal) together with the interest must be repaid over a fixed
period of time
1- Loans are classified according to security, i.e. secured or unsecured loans
2- Loans are classified according to type of borrower, i.e. personal or business
loans
3- Loans classified according to the term of the loan, i.e. short term or long
term loans
4- Loans classified according to sector, i.e. retail, manufacturing, etc. The
sectorization helps the regulators to see how credit is flowing in different
sectors.
5- Loans are classified according to region: Regulatory authority may also be
concerned about the flow of credit in the different regions of the country.
6- Loans classified according to purpose, i.e. home loans, constructions , etc.
 Traditional types of advances
Overdrafts:

 This is like running account, where there are no lump sum payments nor a
repayment in installments over a period of time. The borrower
 Overdraft facilities are only allowed for current accounts
 An Overdraft is a fluctuating account, i.e. sometimes it is in credit and in
other times it could be in debit
 Like Loans, Overdrafts can also be classified according to security,
borrower, sector, etc.
 Credit cards are special forms of overdraft and they provide consumers
with a means of obtaining credit if required
Modern types
 Equity Participation: Lending institutions supply equity capital
to satisfy the long term financing needs of large businesses.
 Loan Syndication: involves two or more lenders jointly
meeting the large financial needs of a corporate customer. It
may be difficult for one single lender to meet the requirement
of a very large company.
 Equipment leasing: A lease is a contract under which the lessor
(lender) hires out specific equipment to a lessee (borrower).
 Factoring: it is the purchase of debts by institutions. The lender
purchase the trade debts of a business (at a discount) and pays
the business in cash
Different Types of Borrowers
 Minors: This is a person who has not yet reached the age of 18,
consequently he should not be granted a loan. A minor cannot be
compelled to repay the money that he/she borrowed.
 Persons of unsound mind: If a person of unsound mind can prove that
he/she was so at the time of entering into a loan contract, then the
liability under the contract can be avoided.
 Insolvents: A financial institution should not lend to an un-discharged
insolvent or a person against whom insolvency proceedings are pending
 Joint Account: A joint account is a bank account conducted in the
names of two or more persons who are not partners
 Husband and wife: The rights and responsibilities of husband and wife
are similar to those of other joint account holders.
Business Borrowers
There are different forms of business and hence different types
of business borrowers
 Sole Proprietorship: is a business that an individual owner
conducts in his/her name or a trade name
 Partnership: is a relation between persons who have agreed to
share the profits of a business carried on by all or any one of
them acting for all.
 Companies: is an artificial person created by law, consequently
it needs some natural person to act on its behalf. Lenders must
make sure that there is a resolution by the BOD to borrow and
the borrowing is within the borrowing powers of the company.
Special types of borrower
The special types of borrowers are not individuals or business. They are:
 Local Authorities: Can be a council of a city created to govern the
borrowing power. Lenders need to examine the extent to which the
authority can borrow.
 Clubs, Schools: These have no legal entity like a company and have no
power to enter into contractual relations. Such organizations usually
register as unincorporated associations. Lenders are therefore, requested
to examine the bylaws of such organizations.
 Unincorporated association: These are charity organizations and
therefore, lenders should take precautions (same as for clubs)
 Co-operatives: organizations established for the benefit of members
Must be treated in similar manner to clubs and unincorporated
organizations.
Structuring of advances
It involves three major aspects: Obtaining security,
deciding on the debt covenants and pricing
 Security: There are different types of securities, each of
which is having its own documentations. They include:
- Land
- Guarantees obtained from company directors
- For personal borrowers, an equitable mortgage over
assets
- etc.
Perfecting the Security Interest

The security is said to be perfected, when the bank's claim is

superior to that of other creditors and the borrower
 Require the borrower to sign a security agreement that assigns
the qualifying collateral to the bank
 Bank obtains title to equipment or vehicles
Debt covenants

 Lenders may impose additional covenants to ensure

added protection.
 Some covenants are regarded as negative and others
are regarded as positive
Pricing issue
 These include the interest rates and fees to be
charged on advances.
 Most lenders have a rate base to which they add a
margin (risk premium).
 Lenders generally charge the following fees:
- establishing fee (commitment fee)
- Application fee
- loan administration fee
- unused limit fee
Credit Culture

 The fundamental principles that drive lending activity

and how management analyzes risk
 Values Driven
 Focus is on credit quality
 Current-Profit Driven
 Focus is on short-term earnings
 Market-Share Driven
 Focus is on having the highest market share
Designing advances Portfolio
 Loans represent more than 70% of total assets of a typical financial
institution, therefore, top management & portfolio managers’ major
task is to design loan portfolios.
 The strategic decisions of these managers, when making portfolio
selections include the following:
- What resources are available to invest?
- What proportion of these resources should be invested in advances
- What proportion of these advances will be invested in personal
loans and what proportion for business loans
 The designing of the loan portfolio s about finding answers to these
questions.