Chapter 5

Providing loans to
businesses and
consumers

Peter Rose, Chapter 16, 17, 18

1
 Part 1

Lending Policies and

Procedures: Managing
Credit Risk
2
 Content
• Types of Loans Banks 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

3
 Types of Loans made by banks

• Real Estate Loans

• Financial Institution Loans
• Agriculture Loans
• Commercial and Industrial Loans
• Loans to Individuals
• Miscellaneous Loans
• Lease Financing Receivables

4
 Loans
Outstanding for
U.S. Banks
(2007)

5
 Factors Determining the Mix of
Bank Loans

01 02 03 04 05
Characteristics Lender Size Experience Expected Yield Regulations
of Market Area and Expertise of Each Type
of of Loan
Management

6
 Regulation of Lending
CAMELS Rating System

• Capital Adequacy
• Asset Quality
• Management Quality
• Earnings Record
• Liquidity Position
• Sensitivity to Market Risk

7
 Asset Quality

• Criticized Loans
• Scheduled Loans
• Adversely Classified Loans
• Substandard Loans
• Doubtful Loans
• Loss Loans

8
 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 to Monitor Bank
Behavior.

9
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10
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11
 Establishing a Good Written Loan Policy

• Goal Statement for Bank’s Loan Portfolio

• Specification of Lending Authority of Each Loan Officer and
Committee
• Lines of Responsibility in Making Assignments and Reporting
Information
• Operating Procedures for Soliciting, Evaluating and Making
Loan Decisions
• Required Documentation for All Loans
• Lines of Authority for Maintaining and Reviewing Credit Files

12
 Bank’s Written Loan Policy (cont.)

• Guidelines for Taking and Perfecting Collateral

• Procedures for Setting Loan Interest Rate
• Statement of Quality Standards for All Loans
• Statement of Upper Limit for Total Loans Outstanding
• Description of the Bank’s Principal Trade Area
• Procedures for Detecting, Analyzing and Working Out
Problem Loans

13
 Quick Quiz

• Why is lending so closely regulated by state and federal

authorities?
• What is the CAMELS rating, and how is it used?
• List several elements of a good written loan policy.

14
 Steps in the Lending Process

Finding Evaluating Making Evaluating Assessing Monitoring

Finding Evaluating a Making Site Evaluating a Assessing Monitoring
Prospective Customer’s Visits and Customer’s Possible Loan Compliance
Loan Character and Evaluating a Financial Collateral and with the Loan
Customers Sincerity of Customer’s Record Signing the Agreement
Purpose Credit Record Loan and Other
Agreement Customer
Service
Needs

15
 The Six Basic C’s of Lending

1 2 3 4 5 6

Character – Capacity – Cash – Ability Collateral – Conditions – Control – Does

Specific Legal Authority to Generate Adequate Economic Loan Meet
Purpose of to Sign Binding Enough Cash Assets to Conditions Written Loan
Loan and Contract to Repay Loan Support the Faced By Policy and
Serious Intent Loan Borrower How Would
to Repay Loan Loan Be
Affected By
Changing
Laws and
Regulations

16
The Six Basic C’s of Lending

17
 Common Types of Loan Collateral

Reasons for Taking Collateral

Types of Collateral:
• Accounts Receivables
• Factoring
• Inventory
• Real Property
• Personal Property
• Personal Guarantees

18
 Information About Consumers

1. Consumer-Supplied Financial Statements

2. Credit Bureau Reports
3. Experience of Other Lenders
4. Verification of Employment
5. Verification of Property Ownership
6. The Web

19
 Information About Businesses

01 02 03 04
Financial Reports Copies of Board Credit Ratings – The World Wide
Supplied by the of Director’s Dun & Bradstreet, Web
Borrowing Firm Resolutions or Moody’s,
Partnership Standard &
Agreements Poor’s

20
 Information About Governments

• Government Budget Reports

• Credit Ratings Assigned to Government Borrowers By
Moody’s, Standard & Poor’s, Fitch
• Web

21
 Parts of a Typical Loan Agreement
• The Promissory Note
• Loan Commitment Agreement
• Collateral
• Covenants
• Affirmative
• Negative
• Borrower Guaranties and Warranties
• Events of Default

22
• Examination of Outstanding
Loans to Make Sure
Borrowers are Adhering to
Their Credit Agreements Loan
and the Bank is Following
Its Own Loan Policies
Review

23
 Reviewing Conducting Accelerating

Reviewing Largest Conducting More Accelerating the Loan

Loans Most Frequently Frequent Reviews of Review Schedule if
Troubled Loans Economy or Industry
Experiences Problems

Loan Review Procedures (cont.)

24
 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 Predictions
8. Unexpected and Unexplained Changes in Deposits
25
 Loan Workouts

• The Process of Resolving a

Troubled Loan So the Bank Can
Recover Its Funds

26
 Loan Workout Process
1. Goal is to Maximize Full Recovery of Funds
2. Rapid Detection and Reporting of Problems is Essential
3. Loan Workout Should Be Separate From Lending Function
4. Should Consult With Customer Quickly on Possible
Options
5. Estimate Resources Available to Collect on Loan
6. Conduct Tax and Litigation Search
7. Evaluate Quality and Competence of Management
8. Consider All Reasonable Alternatives

27
 Quick Quiz
• What are the typical steps followed in receiving a loan
request from a customer?
• What three major questions or issues must a lender
consider in evaluating nearly all loan requests?
• Explain the following terms: character, capacity, cash,
conditions, and control.
• What are the principal parts of a loan agreement? What is
each part designed to do?
• What are some warning signs to management that a
problem loan may be developing?

28
 Content
• Types of Business Loans: Short-Term and Long-Term
• Analyzing Business Loan Requests
• Collateral and Contingent Liabilities
• Sources and Uses of Business Funds
• Lending to SMEs
• Pricing Business Loans
• Customer Profitability Analysis (CPA)

29
 Short Term Business Loans
• Self-Liquidating Inventory Loans
• Working Capital Loans
• Interim Construction Loans
• Security Dealer Financing
• Retailer and Equipment Financing
• Asset-Based Financing
• Syndicated Loans

30
 Long Term Business Loans
1. Term Loans
2. Revolving Credit Lines
3. Project Loans
4. Loans to Support Acquisitions of Other Business Firms

• Question: What are the essential differences between

various short- and long-term business loans?

31
 Sources of Repayment for Business Loans

1. The Borrower’s Profits or Cash Flows

2. Business Assets Pledged as Collateral
3. Strong Balance Sheet With Ample Marketable Assets and
Net Worth
4. Guarantees Given By Businesses

32
 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

33
 Financial Ratio Analysis
1. Control Over Expenses
2. Operating Efficiency
3. Marketability of Product or Service
4. Coverage Ratios: Measuring Adequacy of Earnings
5. Liquidity Indicators for Business Customers
6. Profitability Indicators
7. The Financial Leverage Factor as a Barometer of a
Business Firm’s Capital Structure

34
 Expense Control Measures
1. Cost of Goods Sold/Net Sales
2. Selling, Administrative and Other Expenses/Net Sales
3. Depreciation Expenses/Net Sales
4. Interest Expenses on Borrowed Funds/Net Sales
5. Taxes/Net Sales

35
 Operating Efficiency
1. Annual Costs of Goods Sold/Average Inventory
2. Average Receivables Collection Period
3. Net Sales/Net Fixed Assets
4. Net Sales/Total Assets
5. Net Sales/Accounts Receivables

36
 Marketability of Product or Service

1.Gross Profit Margin

=(Net Sales-CGS)/Net Sales
2. Net Profit Margin
=Net Income After Taxes/Net Sales

37
 Coverage Measures

1. Interest Coverage
2. Coverage of Interest and Principal
Payments

38
 Liquidity Measures
1. Current Assets/Current Liabilities
2. Acid Test Ratio
3. Working Capital
4. Net Liquid Assets

39
 Profitability Measures
1. Before Tax Net Income/Total Assets
2. After Tax Net Income/Total Assets
3. Before Tax Net Income/Net Worth
4. After Tax Net Income/Net Worth

40
 Leverage or Capital Structure Measures

1. Leverage Ratio
2. Total Liabilities/Net Worth
3. Capitalization Ratio
4. Debt to Sales Ratio

41
 Types of Contingent Liabilities
1. Guarantees or Warrantees Behind Products
2. Litigation or Pending Lawsuits
3. Unfunded Pension Liabilities
4. Taxes Owed But Unpaid
5. Limiting Regulations

42
 Component of Sources and Uses of Funds
Statement
1. Cash Flows from Operations
2. Cash Flows from Investing Activities
3. Cash Flows from Financing Activities

43
 Traditional (Direct) Operating Cash Flows

• Net Sales Revenue – Cost of Goods Sold – Selling, General

and Administrative – Taxes Paid in Cash + Non Cash
Expenses

44
 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

45
Analysis of a Business Borrower’s
Financial Statements

46
Analysis of a Business Borrower’s
Financial Statements

47
Financial Ratio Analysis of a Customer’s
Financial Statements

48
Financial Ratio Analysis of a Customer’s Financial Statements

49
 Financial Ratio Analysis of a Customer’s
Financial Statements
• A. The Business Customer's Control over Expenses
• B. Operating Efficiency: Measure of a Business Firm's
Performance Effectiveness
• C. Marketability of the Customer's Product or Service
• D. Coverage Ratios: Measuring the Adequacy of Earnings
• E. Liquidity Indicators for Business Customers
• F. Profitability Indicators
• G. The Financial Leverage Factor as a Barometer of a
Business Firm's Capital Structure

50
 Loan pricing model
• Target rate of return
• Customer credit risk, quantified as a “probability of default”
and credit rating: The higher the default probability, the
higher the loan interest rate will be;
• Loss-given-default (LGD), also known as recovery rate
(RR): This is the amount of the loan value that will be
recovered after customer default. The higher the LGD (that
is, the lower the RR) the higher the loan rate will be;
• Collateral: If the loan is provided unsecured (“clean”), it will
be priced at a higher rate than if it is secured.
• Funds transfer “price” (FTP): There is an additional pricing
factor in all but the simplest banks, and that is an internal
pricing input that in theory will be seeking to cover the
bank’s term liquidity premium (TLP). This is the FTP rate
supplied by the Treasury department. 51
 Methods Used to Price
Business Loans

1. Cost-Plus Loan Pricing Method

2. Price Leadership Model
3. Below Prime Market Pricing
4. Customer Profitability Analysis

52
 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

Cost-plus-profit pricing requires the bank to estimate the total cost involved in making a
loan and then adds to that cost estimate a small margin for profit.

53
 Cost-Plus Loan Pricing

• In order to help fund a loan request of $10 million for one year
from one of its best customers, Lone Star Bank sold negotiable
CDs to its business customers in the amount of $6 million at a
promised annual yield of 3.50 percent and borrowed $4 million in
the Federal funds market from other banks at today’s prevailing
interest rate of 3.25 percent.
• Credit investigation and recordkeeping costs to process this loan
application were an estimated $25,000. The Credit Analysis
Division recommends a minimal 1 percent risk premium on this
loan and a minimal profit margin of one-fourth of a percentage
point. The bank prefers using cost-plus loan pricing in this cases.
What loan rate would it charge?
54
 Price Leadership Model

Default
Risk Term Risk
Loan
Base or Premium Premium for
Interest = + +
Prime Rate for Non- Longer
Rate
Prime Term Credit
Borrowers

The price-leadership model, on the other hand, bases

the loan rate upon a national or international rate
(such as prime or LIBOR) posted by major banks and
then adds a small increment on top for profit or risk.
55
 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
 LIBOR

• The London Interbank Offer Rate. The Rate

Offered on Short-Term Eurodollar Deposits With
Maturities Ranging From a Few Days to a Few
Months

57
 Below-Prime Market Pricing

Interest Cost
Loan Markup
of Borrowing
Interest = + for Risk
in the Money
Rate and Profit
Market

58
 Customer Profitability Analysis (CPA)
1. Estimate Total Revenues From Loans and Other Services
2. Estimate Total Expenses From Providing Net Loanable
Funds
3. Estimate Net Loanable Funds
4. Estimate Before Tax Rate of Return By Dividing Revenues
Less Expenses By Net Loanable Funds

59
Try it: #

60
Try it: #

61
 Quick Quiz
1. What aspects of a business firm’s financial statements do
loan officers and credit analysts examine carefully?
2. What methods are used to price business loans?
3. Suppose a bank estimates that the marginal cost of
raising loanable funds to make a $10m loan to one of its
corporate customers is 4%, its nonfunds operating costs
to evaluate and offer this loan are 0.5%, the default-risk
premium on the loan is 0.375%, a term-risk premium of
0.625% is to be added, and the desired profit margin is
0.25%. What loan rate should be quoted this borrower?
How much interest will this borrower pay in a year?

62
 PART 3

Consumer Loans, Credit Cards,

and Real Estate Lending

63
 Content
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

64
 Consumer Lending
1. Has been among the most popular financial services
offered in recent years
2. 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
3. On the other hand, presents a special challenge due to
higher-than-average default rates.

65
Consumer Lending: Outstanding Balance by Category: Value 2011-2016
Source: Euromonitor International from official statistics, nov.2016

66
 Forecast Consumer Credit:
Outstanding Balance by Category:
% Value Growth 2016-2021
Sourche: Euromonitor, 2016

67
 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
• Noninstallment Loans
• Credit Card Loans and Revolving Credit

68
 Residential Mortgage Loans
• Credit to Finance the Purchase of Residential Property in
the Form of Houses and Multifamily Dwellings.
• This is Usually a Long-Term Loan (15-30 years) Which is
Secured By the Property Itself.
• Fixed or Variable Rate of Interest

69
 Nonresidential 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
Consolidate Existing Debt (automobile, furniture,
appliances).

70
 Noninstallment Loans
• Short-Term Loans By Individuals for Immediate Cash Needs
and Repayable in One Lump Sum When the Borrower’s
Note Matures (charge accounts, medical care, auto and
home repairs)

71
 Credit Card Loans
• Credit Cards Offer Holders Access to Either Installment or
Noninstallment Credit.
• 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.

72
 • Credit Cards: Number of
Cards in Circulation 2011-
2016

• Credit Cards in Circulation:

% Growth 2011-2016

• Forecast Credit Cards:

Number of Cards in
Circulation 2016-2021

Credit Cards in Vietnam

Source: Euromonitor International, Oct. 2016

73
 Try it:#
• Credit card companies allow customers with balances to
pay a minimum amount, instead of the full amount each
month. What remains unpaid accumulates interest at
sometimes quite high interest rates.
• Suppose you have charged $1,000 and choose to pay the
minimum balance of 2% at the end of each month. And
suppose your credit card company charges 30% APR
interest, with monthly compounding.
• How much will you owe after 12months if you implement the
strategy of paying the minimum?

74
Forecast Credit Cards Transactions
2016-2021
Source: Euromonitor International, Oct. 2016

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 76
credit card accounts.
 Debit Cards
• Debit Cards 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.

77
 • Debit Cards: Number of Cards in
Circulation 2011-2016

• Forecast Debit Cards: Number of

Cards in Circulation 2016-2021

• Forecast Debit Cards

Transactions 2016-2021

Debit cards

78
Characteristics of Consumer
Loans

• Most Costly and Most Risky to Make Per Dollar

• Cyclically Sensitive

• Interest Inelastic

79
 Evaluating a Consumer Loan Application

• Character and Purpose

• Income Levels
• Deposit Balances
• Employment and Residential Stability
• Pyramiding of Debt

80
 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

81
 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.

82
Credit Scoring

83
 PART 2

Lending to Business
Firms and Pricing
Business Loans

84
LENDING
TO SME
CREDIT SCORE
CARD
USED

85
LENDING
TO SME
CREDIT SCORE
CARD
USED

86
LENDING
TO SME
CREDIT SCORE
CARD
USED

87
• LENDING
TO SME
CREDIT SCORE
CARD
USED

88
LENDING
TO SME
CREDIT SCORE
CARD
USED

89
 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

90
 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

91
 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

92
 Quick Quiz
1. How do credit-scoring systems work? What are the
principal advantages to a lending institution of using a
credit-scoring system?
2. In what ways is a real estate loan unique compared to
other kinds of bank loans?
3. What factors should a lender consider in evaluating real
estate loan applications?
4. What legal protections are available today to protect
borrowers against discrimination? Against predatory
lending?
5. What forces are reshaping household lending today?
93
 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

94
 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

95
 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

96
 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.

97
 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

98
 Quick Quiz

• What options does a loan officer have in pricing

consumer loans?
• Suppose a customer is offered a loan at a discount rate
of 8% and pays $75 n interest at the beginning of the
term of the loan. What net amount of credit did this
customer receive? Suppose you are told that the
effective rate on this loan is 12%. What is the average
loan amount the customer has available during this
year?

99