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Chapter 16

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Chapter Sixteen

Lending Policies and Procedures:

Managing Credit Risk

1. Introduction
• Credit is a mean of borrowing money to finance consumption or
business needs for a specified period of time to be returned at a
later date with interest.

• 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

• The lending process bears careful monitoring at all times

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1. Introduction- cont’d
• Every bank bears a degree of risk when it lends so it
experiences some loan losses when certain borrowers fail to
repay their loans as agreed.

• The main objective of the bank is not to make loans, but to

minimize risk in collecting them. Thus the true core of
business of banking is the profitable management of risk.
• The trick is to create loan management packages and
management systems that maximize banks’ chances of getting
the money back.

• Credit management is important since it affects bank’s

profitability, which can lead to bank failure, thus affecting
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1. Introduction- Cont’d
Several faults in lending procedures such as:
1. Inattention to loan policies: define in what industries to be
involved
2. Overlay generous loan terms and lack of clear standards.
3. Unsafe concentration of credit (failure to diversify)
4. Poor control over loan personnel (unqualified personnel)
5. Loan growth beyond the banks’ ability to control quality.
6. Poor systems for detecting loan problems.
7. Lack of understanding of borrowers’ cash needs
(overburdening customer)
8. Out-of- market lending (lend where no one else is lending)
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1. Introduction- Cont’d
Other faults
9. Overvalued collateral
10. Dispersal of funds before documentation is finished.
11. Loan to a new business with an inexperienced owner
12. Funds not applied as represented; diverted to
borrower’s personal use.
13. Lending against fictitious book net worth of
business, with no audit or verification of borrower’s
financial statements.
14. Renewing a loan for increasing amounts, with no
additional collateral taken.
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Key Topics
1. Introduction
2. Credit Risk Management Strategy
3. Types of Loans Made by Banks
4. Factors Affecting the Mix of Loans Made
5. Regulation of Lending
6. Creating a Written Loan Policy
7. Steps in the Lending Process
8. The Credit Process and Credit Analysis
9. Parts of a Typical Loan Agreement
10. Loan Review and Loan Workouts
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2. Credit Risk Management
• Bank credit risk is divided into two parts: transaction risk
and portfolio risk
• Transaction risk is divided into:
▫ Bank’s credit organization
▫ Bank’s credit investigation and analysis
▫ Bank’s standard for underwriting loans
 Collateral accepted, terms written, etc….
• Portfolio risk is divided into
▫ Intrinsic risk: risk unique to specific borrower
▫ Concentration risk: proportion of banks’ loans that are tied
up in certain industries or geographical areas
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3. Types of Loans
By purpose
• Real Estate Loans: construction, purchase homes and
apartment
• Financial Institutions Loans: banks, insurance companies,
finance companies
• Agriculture Loans: farm, planting, harvesting crops, feeding
of livestock
• Commercial and Industrial Loans
• Loans to Individuals
• Lease Financing Receivables
• Miscellaneous Loans (other types of loans)
By security: secured vs. unsecured
By term of loan: short, medium, or long
The largest category in dollar volume is real estate loans,
followed by loans to individuals, and commercial and
industrial (C&I) loans
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TABLE 16–1 Loans Outstanding for All FDIC-Insured Banks as of

December 31, 2010 (consolidated domestic and foreign offices)

4. Factors Determining the Growth and Mix

of Loans
• Characteristics of the market area
• Lender size
• Wholesale lenders vs. retail credit
• Wholesale lenders give bulk loans to business firms, while retail
lenders give bulk loans to personal loans and mortgage loans.
• Experience and expertise of management
• Loan policy
• Regulation
• Expected yield of each type of loan
• Gross yield (total revenue/loans volume) vs. net yield (with
expenses and loss rates deducted from revenues received)
General rule: A lending institution should make the types of loans for
which it is the most efficient producer
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5. Regulation of Lending
• The mix, quality, and yield of the loan portfolio are heavily
influenced by regulation
• Because the quality of examination information decays very
quickly, regulators are starting to use market forces and private
market discipline to monitor bank behavior

• 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

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5. Regulation of Lending (continued)
• Red Rose has the following sources of funds: $300 million in capital
and surplus, $325 million in demand deposits, $680 million in time
and savings deposits, and $200 million in subordinated debt.
• What is the maximum dollar amount of real estate loans that
RRNB can grant?

▫ Capital and surplus: $300 million

▫ 70 percent of time and savings deposits: 0.7*680=$476 million
 Therefore, maximum amount of real estate loans that RNRB can
grant is $476 million.

• What is the maximum dollar amount RRNB may lend to a single

customer?
▫ 300*0.15= $45M, a further amount of $300*0.1=$30 million can be
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5. Regulation of Lending (continued)

• The Community Reinvestment Act of 1977
▫ Selected lenders 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
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5. Regulation of Lending (continued)
• Credit Limits in Lebanon

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5. Regulation of Lending (continued)
• Credit Limits in Lebanon

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5. 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

5. Regulation of Lending (continued)

• A common procedure for examiners is to multiply the total
of all:
• Substandard loans by 0.2
• Doubtful loans by 0.5
• Bad loans by 1

Sum thee weighted amounts and compare the grand total to the
Allowance for Loan Losses (ALL) account

• Accordingly, a bank may be asked to either increase the

ALL account or equity

5. Regulation of Lending (continued)

• Numerical ratings can be also assigned based on examiner’s
judgement of the following:
▫ 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 (ratings 4 and 5)
tend to be examined more frequently than the highest-rated
institutions (ratings 1,2, and 3).
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5. Regulation of Lending (continued)

Capital Adequacy:
Capital ratio as Tier 1 and Tier 2 as percentage of bank risk weighted assets

Asset Quality
• Loans that are performing well but have minor weaknesses because the lenders has
not followed its own loan policy or has failed to get full documentation from the
borrower are called criticized loans
• Loans that appear to contain significant weaknesses or that represent what examiners
regard as a dangerous concentration of credit in one borrower or one industry are
called scheduled loans

• Adversely classified loans: carry immediate risk of not paying out

• Substandard loans: inadequately protected by net worth and paying capacity of
borrower or collateral; bank will sustain a loss if deficiencies are not corrected
(20% reserve)
• Doubtful loans: all weaknesses of substandard loans but have deteriorated, so they
have high probability of loss (50% reserve)
• Loss loans: uncollectible with little or no value as an asset (100% reserve)
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5. Regulation of Lending (continued)
Asset Quality (continued)
• Adversely Classified are also called Non-performing
(Noncurrent) Loans
• These are credits that no longer accrue interest income or that
have had to be restructured to accommodate a borrower’s
changed circumstances
• In Lebanon:
• A loan is placed in the nonperforming category when any
scheduled loan repayment is past due for more than 90 days, and
any accrued interest on the loan recorded, but not received, must
be deducted from loan revenues, and can not be recorded as
interest income
Substandard Doubtful Bad
> 90 days 91 – 180 days > 180 days
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5. Regulation of Lending (continued)

• Management Quality:
• Corporate governance; clearly defined authorities and
responsibilities; appointment of internal/external auditors

• Earning record
• Income Statement

• Liquidity Position
▫ Liquidity ratios such as liquid assets/ total assets; loans/
deposit; liquid assets/deposits, etc.

• Sensitivity to market risk

• Risk of loss in income as a result of changes in market
conditions
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6. Establishing Written Loan Policy

▫ Loan Policy should reflect bank’s lending culture, including
priorities, procedures, and means of monitoring lending activity

▫ Must be in written form to ensure that it is communicated to all

concerned

▫ Loan Policy might change over time and over the credit cycle
▫ Weak economy => borrowers need to show greater balance sheet
and earning strengths

▫ Loan policy should be updated on periodic basis

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6. Twelve Elements of a Good Loan Policy
1. A goal statement for the entire loan portfolio in terms of
types, maturities, liquidity, sizes, and quality
 E.g. Make loans that meet the credit needs of community while
simultaneously maintaining safety, liquidity, and social and
financial returns.

2. Specification of lending authority of each loan officer and

loan committee including the maximum amount and types of
loan that each person and committee can approve and
signatures required
 How many people does it take to approve a loan? What is
approved by loan committee?

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6. Twelve Elements of a Good Loan Policy
3. Lines of responsibility for making assignments and
reporting information within the lending division
Example:
- Loan applications will be taken by individual lenders or assigned by
the Chief Lending Officer.

4. Operating procedures for soliciting, reviewing,

evaluating, and making decisions on customer loan
applications
Underwriting criteria by loan type:
- Real Estate, Business, Single-Family Mortgage, Construction Lending,
Microfinance, etc.
- Size and complexity of loan
- Purpose and source of repayment
- Borrower’s ability to repay on time
- Borrower eligibility criteria
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6. Twelve Elements of a Good Loan Policy
5. The required documentation that accompanies each loan
application and what must be kept in bank’s credit files
▫ Basic loan agreement
▫ Loan application
▫ Borrower’s financial statement
▫ Loan report
▫ Collateral information and other relevant documentation used in
making the credit decision or reviewed prior to loan closing
▫ Perfection of security interest (legal claim to collateral)
▫ Insurance documents on borrower’s life or on property
▫ Corporate borrowing partnership agreement
▫ Disbursement records
▫ Risk rating records
▫ Guarantor’s financial statement
▫ Project budgets and Project pro-forma
▫ Copies of existing and paid-off promissory notes
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6. Twelve Elements of a Good Loan Policy
6. Lines of authority detailing who is responsible for maintaining
and reviewing the credit files

7. Guidelines for taking, evaluating, and perfecting loan collateral

8. Policies and Procedures for setting loan rates and fees and the
terms for repayment of loans

9. A statement of quality standards applicable to all loans

Example:
Average Risk – Collateral, cash flow and credit cover loan
(LTV 90%)
Substantial Risk – Tight collateral coverage or cash flow of
debt service is tight (less than 1.05)
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6. Twelve Elements of a Good Loan Policy
10. A statement of the preferred upper limit for total
loans outstanding/concentrations
Example: In order to reduce risks in its portfolio following
limits as a percentage of lending capital are set:
- 15% to any one borrower
- 25% to one type of business
- 35% in unsecured loans
- 25% in one geographic area

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6. Twelve Elements of a Good Loan Policy

11. A description of the lending institution’s principal

trade area, from which most loans should come
 Primary and secondary area should be stated by the loan
policy, such as the area to be served.

12. Procedures for detecting, analyzing, and working out

problem loan situations.
 Example: If by the 90th day no payment has been received,
the Loan Committee will examine the situation.

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7. Steps in the Lending Process

1. Finding Prospective Loan Customers (individuals an
companies)
 “Sales Position” (loan officers “sell” their loans to customers)

7. Steps in the Lending Process

2. Evaluating a Customer’s Character and Sincerity of Purpose
 Interview with a customer
3. Making Site Visits and Evaluating a Customer’s Credit Record
 To assess the customer’s location and the condition of the property
4. Evaluating a Prospective Customer’s Financial Condition
 Complete financial statements
 BOD Resolutions
 Thorough financial analysis
 Brief summary and recommendation (to loan committee for approval)

7. Steps in the Lending Process

5. Assessing Possible Loan Collateral and Signing the Loan
Agreement
 “Perfecting” the lender’s claim to collateral
 Signature of the loan agreement
 6. Monitoring Compliance with the Loan Agreement and Other
Customer Service Needs
 Continuous monitoring
 On-site visits
 Maintain “Customer Profile”

8. 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
▫ Cash flows from income
▫ Cash from selling assets
▫ Funds by issuing debt/equity

8. Credit Analysis: What Makes a Good Loan?

1. Is the Borrower Creditworthy? The Cs of Credit
▫ Collateral
▫ Adequate assets to support the loan
▫ Age, condition, and degree of specialization

▫ Conditions
▫ Economic conditions faced by borrower

▫ Control
▫ Does loan meet written loan policy and how would loan be affected by
changing laws and regulations

8. Credit Analysis: What Makes a Good Loan?

1. Is the Borrower Creditworthy? The Cs of Bad Credit
▫ Complacency
▫ Over-reliance on the past record of the borrower, despite other
changing circumstances
▫ Carelessness
▫ Poor documentation or underwriting protocols
▫ Communication
▫ Poor information flows between borrower and lender
▫ Contingencies
▫ Tendency to ignore bad things that might impact a loan’s
performance
▫ Competition
▫ Replicating competitor behavior without adhering to the bank’s
own credit philosophy
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8. Credit Analysis: What Makes a Good Loan?

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

▫ Proper accommodation of a customer may involve lending more or

less money than requested over a longer or shorter period
▫ A properly structured loan agreement must protect the lender by
imposing certain restrictions on borrower activities
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8. Credit Analysis: What Makes a Good Loan?

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

▫ When a lender holds a claim against a borrower’s assets that stands

superior to the claims of other lenders and to the borrower’s own
claim, we say that lender’s claim to collateral has been perfected

8. Credit Analysis: What Makes a Good Loan?

3. Can the Lender Perfect Its Claim against the Borrower’s
Earnings and Any Assets That May Be Pledged as Collateral?
▫ Types of Collateral
▫ Accounts Receivables (usually between 40 and 90 percent)
▫ Factoring (the receivables are sold to a factor)
▫ Inventory (30 to 80 percent)
▫ Real Property (the borrower purchases insurance with the lending
institution receiving first claim on any insurance settlement made).
▫ Personal Property (automobiles, furniture and equipment, jewelry,
securities and other forms of personal property)
▫ Personal Guarantees (A pledge of the stock, deposits, or other personal
assets held by the major stockholders or owners of a company)
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8. Credit Process
The credit process is summarized as:
Credit Philosophy => credit culture => lending policies and
procedures
• Credit Philosophy: Management’s philosophy that determines
risk tolerance (how much risk the bank will take and in what form)
• Credit culture: Fundamental principles that drive the actual
lending activity and how management analyzes risk
▫ Values Driven
▫ Current-Profit Driven
▫ Market-Share Driven
• Loan Policy: Formalizes lending guidelines that employees
follow to conduct bank business
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8. Credit Process- Cont’d

Value Driven Current Profit Market Share

Driven Driven
Focus Credit Quality Short term Highest market
earning share of loans
Emphasis Bank soundness Annual profit Loan volume
and stability and growth
Underwriting Conservative Lending to high Aggressive with
(assuming underwriting risk and return significant loan
financial risk) with no loan concentration
concentration and above
average risk
Outcome Lower but stable Higher profit in Loan quality
profit, with few good times, suffering over
loan loss lower profit in time and
bad times modest profit
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9. Parts of a Typical Loan Agreement

• The Promissory Note

• Loan Commitment Agreement
• Collateral
• Covenants
▫ Affirmative
▫ Negative

• Borrower Guaranties or Warranties

• Events of Default

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9. Parts of a Typical Loan Agreement
• Promissory note:
It is signed by the borrower and it specifies the principal amount of the
loan, the interest rate and the terms under which repayment must take
place (including dates).
• Loan commitment Agreement
This is done for larger business loans and home mortgage loans. The
bank promises to make credit available to the borrower over a designated
future period up to a maximum amount in return for a commitment fee.
• Collateral
Secured loan agreements include a section describing any assets that are
pledged as collateral, along with an explanation of how and when the
bank can take possession of the collateral in order to recover its funds.

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9. Parts of a Typical Loan Agreement
• Covenants
Most formal loan agreements also contain restrictive covenants,
which are usually one of two types: affirmative or negative
1. Affirmative covenants: require the borrower to take certain
actions such as periodically filing financial statements with the
bank, maintaining insurance coverage on the collateral pledged.
2. Negative covenants: restrict the borrower from doing certain
things without the bank's approval, such as taking on new debt,
acquiring additional fixed assets, participating in mergers, or
selling assets.

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duplicated, in whole or in
part, except for use as
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distributed with a certain
product or service or
otherwise on a
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9. Parts of a Typical Loan Agreement
• Borrower Guaranties or Warranties
The borrower guarantees or warrantees that the information supplied in the
loan application is true and correct. The borrower may also be required to
pledge personal assets behind a business loan or against a loan that is
cosigned by a third party.
• Events of Default
It specify what actions or inactions by the borrower would represent a
significant violation of the terms of the loan agreement and what actions
the bank is legally authorized to take in order to secure the recovery of its
funds.
The events-of-default section also clarifies who is responsible for
collection costs, court costs, and attorney's fees that may arise from
litigation of the loan agreement.

10. Loan Review

Examination of Outstanding Loans to Make Sure Borrowers are
Adhering to Their Credit Agreements and the Bank is Following Its
Own Loan Policies
1. Carrying out reviews of all types of loans on a periodic basis
(largest loans routinely, and random sample of smaller loans)
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
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10. 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 especially as measured by ROE, ROA, and
EBIT
6. Adverse changes in capital structure (equity/debt), liquidity ratio, or
activity ratios
7. Deviations in actual sales from projections
8. Unexpected or unexplained changes in deposits balance maintained by
the customer
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