Chapter Seventeen

Bank Lending: Policies and Procedures

Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 16-2

Key Topics

• Types of Loans Banks and Competing Lenders

Make
• Factors Affecting the Mix of Loans Made
• Regulation of Lending
• Creating a Written Loan Policy
• Steps in the Lending Process
• Loan Review and Loan Workouts

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 16-3

Introduction
• However, risky or not, the principal reason many
financial firms are issued charters of incorporation by
state and national governments is to make loans
• Lenders are expected to supply credit for all legitimate
business and consumer financial needs and to price that
credit reasonably
• Loans support the growth of new businesses and jobs
within the lender’s market area
• Loans frequently convey information to the marketplace
about a borrower’s credit quality
• The lending process bears careful monitoring at all
times
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 16-4

Types of Loans
• Real Estate Loans
• Financial Institution Loans
• Agriculture Loans
• Commercial and Industrial Loans
• Loans to Individuals
• Miscellaneous Loans
• Lease Financing Receivables

• The largest category in dollar volume is real estate loans,

followed by loans to individuals, and commercial and
industrial (C&I) loans

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 16-5

TABLE 16–1 Loans Outstanding for All FDIC-Insured Banks as of

December 31, 2010 (consolidated domestic and foreign offices)

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 16-6

Types of Loans (continued)

• Factors Determining the Growth and Mix of Loans
▫ Characteristics of the market area
▫ Lender size
▫ Wholesale lenders vs. retail credit
▫ Experience and expertise of management
▫ Loan policy
▫ Expected yield of each type of loan
▫ Regulation

▫ General rule: A lending institution should make the

types of loans for which it is the most efficient producer

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 16-7

Regulation of Lending
• The mix, quality, and yield of the loan portfolio are heavily
influenced by regulation
• Examples of lending regulations:
▫ The total volume of real estate loans granted by a U.S.
national bank cannot exceed that bank’s capital and surplus
or 70 percent of its total time and savings deposits, whichever
is greater
▫ An unsecured loan to a single customer normally cannot
exceed 15 percent of a single national bank’s unimpaired
capital and surplus account (legal lending limit)
• Any loans made are subject to examination and review

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 16-8

Regulation of Lending (continued)

• The Community Reinvestment Act of 1977
▫ Selected lenders to must make “an affirmative effort” to meet
the credit needs of individuals and businesses in their trade
territories so that no areas of the local community are
discriminated against in seeking access to credit
• The Equal Credit Opportunity Act of 1974
▫ No individual can be denied credit because of race, sex, religious
affiliation, age, or receipt of public assistance
• The International Lending and Supervision Act
▫ Requires U.S. banks to make public any credit exposures to a
single country that exceed 15 percent of their primary capital or
0.75 percent of their total assets, whichever is smaller
▫ This law also imposes restrictions on the fees lenders may charge
a troubled international borrower to restructure a loan
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 16-9

Regulation of Lending (continued)

• Uniform Financial Institutions Rating System
▫ Each banking firm is assigned a numerical rating based on
the quality of its asset portfolio
▫ The federal examiner may assign one of these ratings:
▫ 1 = strong performance
▫ 2 = satisfactory performance
▫ 3 = fair performance
▫ 4 = marginal performance
▫ 5 = unsatisfactory performance

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 16-10

Regulation of Lending (continued)

• Asset Quality
▫ Criticized loans
▫ Scheduled loans
▫ Adversely classified loans
▫ Substandard loans
▫ Doubtful loans
▫ Loss loans

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 16-11

Regulation of Lending (continued)

• CAMELS Rating
▫ Capital adequacy
▫ Asset quality
▫ Management quality
▫ Earnings record
▫ Liquidity position
▫ Sensitivity to market risk exposure
• All six dimensions of performance are combined into one overall
numerical rating, referred to as the CAMELS rating
▫ Depository institutions whose overall rating is low tend to be
examined more frequently than the highest-rated institutions

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 16-12

Regulation of Lending (continued)

• Establishing a Good Written Loan Policy
▫ Important in order to meet regulatory standards
▫ What should a written loan policy contain?
▫ A goal statement for the entire loan portfolio
▫ Specification of lending authority of each loan officer and loan
committee
▫ Lines of responsibility in making assignments and reporting
information
▫ Operating procedures for soliciting, evaluating and making loan
decisions
▫ Required documentation for all loans

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 16-13

Regulation of Lending (continued)

• Establishing a Good Written Loan Policy
▫ Lines of authority for maintaining and reviewing credit files
▫ Guidelines for taking, evaluating, and perfecting loan collateral.
▫ Procedures for setting loan rates and fees and the terms for
repayment of loans
▫ A statement of quality standards applicable to all loans
▫ A statement of the preferred upper limit for total loans
outstanding
▫ A description of the lending institution’s principal trade area
▫ Procedures for detecting and working out problem loan
situations.

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 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 Prospective Customer’s Financial Condition
5. Assessing Possible Loan Collateral and Signing the Loan
Agreement
6. Monitoring Compliance with the Loan Agreement and Other
Customer Service Needs

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 16-15

Credit Analysis: What Makes a Good Loan?

1. Is the Borrower Creditworthy? The Cs of Credit
▫ Character
▫ Specific purpose of loan and serious intent to repay the loan
▫ Capacity
▫ Legal authority to sign binding contract
▫ Cash
▫ Ability to generate enough cash to repay loan
▫ Collateral
▫ Adequate assets to support the loan
▫ Conditions
▫ Economic conditions faced by borrower
▫ Control
1. Does loan meet written loan policy and how would loan be
affected by changing laws and regulations
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 16-16

Credit Analysis: What Makes a Good Loan?

(continued)
2. Can the Loan Agreement Be Properly Structured and
Documented?
▫ This requires drafting a loan agreement that meets the
borrower’s need for funds with a comfortable repayment
schedule
▫ If a major borrower gets into trouble because of an inability to
service a loan, the lending institution may find itself in trouble
2. Proper accommodation of a customer may involve lending
more or less money than requested over a longer or shorter
period

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 16-17

Credit Analysis: What Makes a Good Loan?

(continued)
3. Can the Lender Perfect Its Claim against the Borrower’s
Earnings and Any Assets That May Be Pledged as
Collateral?
▫ Reasons for Taking Collateral
▫ If the borrower cannot pay, the pledge of collateral gives the
lender the right to seize and sell those assets
▫ It gives the lender a psychological advantage over the borrower
▫ Types of Collateral
▫ Accounts Receivables
▫ Factoring
▫ Inventory
▫ Real Property
▫ Personal Property
▫ Personal Guarantees
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 16-18

EXHIBIT 16–1 Safety Zones Surrounding Funds Loaned in

Order to Protect a Lender

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 16-19

TABLE 16–4 Sources of Information Frequently Used in Loan

Analysis and Evaluation by Lenders and Loan Committees

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 16-20

Parts of a Typical Loan Agreement

• The Promissory Note
• Loan Commitment Agreement
• Collateral
• Covenants
▫ Affirmative
▫ Negative
• Borrower Guaranties or Warranties
• Events of Default

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 16-21

Loan Review
1. Carrying out reviews of all types of loans on a periodic basis
2. Structuring the loan review process
▫ Record of borrower payments
▫ Quality and condition of collateral
▫ Completeness of loan documentation
▫ Evaluation of borrower’s financial condition
▫ Assessment as to whether the loan fits with the lender’s loan policies
3. Reviewing Largest Loans Most Frequently
4. Conducting More Frequent Reviews of Troubled Loans
5. Accelerating the Loan Review Schedule if Economy or
Industry Experiences Problems

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 16-22

Loan Workouts
• Loan workout – the process of recovering funds from a problem
loan situation
• Warning Signs of Problem Loans
1. Unusual or unexpected delays in receiving financial statements
2. Any sudden changes in accounting methods
3. Restructuring debt or eliminating dividend payments or changes in
credit rating
4. Adverse changes in the price of stock
5. Losses in one or more years
6. Adverse changes in capital structure
7. Deviations in actual sales from projections
8. Unexpected or unexplained changes in deposits

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 16-23

TABLE 16–5 Warning Signs of Weak Loans and Poor

Lending Policies

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 16-24

Loan Workouts (continued)

• What steps should a lender take when a loan is in trouble?
▫ Do not forget the goal: Maximize full recovery of funds
▫ Rapid detection and reporting of problems is essential
▫ Loan workout should be separate from lending function
▫ Should consult with customer quickly regarding possible options
▫ Estimate resources available to collect on loan
▫ Conduct tax and litigation search
▫ Evaluate quality and competence of management
▫ Consider all reasonable alternatives

1. Preferred option: Seek a revised loan agreement

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 16-25

Quick Quiz
• Why is lending so closely regulated by state and federal
authorities?
• What is the CAMELS rating, and how is it used?
• What three major questions or issues must a lender
consider in evaluating nearly all loan requests?
• Explain the following terms: character, capacity, cash,
collateral, conditions, and control.
• What sources of information are available today that loan
officers and credit analysts can use in evaluating a
customer loan application?
• What is loan review?
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.