Lending Policies and Procedures: Managing Credit Risk Chapter Sixteen Lending Policies and Procedures: Managing Credit Risk McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Key Topics Types of Loans Banks Make 16-2 Key Topics 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

Types of Loans Made By Banks 16-3 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

Loans Outstanding for U.S. Banks (2007) 16-4 Loans Outstanding for U.S. Banks (2007)

Factors Determining the Mix of Bank Loans 16-5 Factors Determining the Mix of Bank Loans Characteristics of Market Area Lender Size Experience and Expertise of Management Expected Yield of Each Type of Loan Regulations

Regulation of Lending: CAMELS Rating System 16-6 Regulation of Lending: CAMELS Rating System Capital Adequacy Asset Quality Management Quality Earnings Record Liquidity Position Sensitivity to Market Risk

Asset Quality Criticized Loans Scheduled Loans 16-7 Asset Quality Criticized Loans Scheduled Loans Adversely Classified Loans Substandard Loans Doubtful Loans Loss Loans

Regulators’ Use of Market Forces 16-8 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

Establishing a Good Written Loan Policy 16-9 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

Bank’s Written Loan Policy (cont.) 16-10 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

16-11 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.

Steps in the Lending Process 16-12 Steps in the Lending Process Finding Prospective Loan Customers Evaluating a Customer’s Character and Sincerity of Purpose Making Site Visits and Evaluating a Customer’s Credit Record Evaluating a Customer’s Financial Record Assessing Possible Loan Collateral and Signing the Loan Agreement Monitoring Compliance with the Loan Agreement and Other Customer Service Needs

The Six Basic C’s of Lending 16-13 The Six Basic C’s of Lending Character – Specific Purpose of Loan and Serious Intent to Repay 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 – Does Loan Meet Written Loan Policy and How Would Loan Be Affected By Changing Laws and Regulations

16-14

Common Types of Loan Collateral 16-15 Common Types of Loan Collateral Reasons for Taking Collateral Types of Collateral: Accounts Receivables Factoring Inventory Real Property Personal Property Personal Guarantees

Information About Consumers 16-16 Information About Consumers Consumer-Supplied Financial Statements Credit Bureau Reports Experience of Other Lenders Verification of Employment Verification of Property Ownership The Web

Information About Businesses 16-17 Information About Businesses Financial Reports Supplied by the Borrowing Firm Copies of Board of Director’s Resolutions or Partnership Agreements Credit Ratings – Dun & Bradstreet, Moody’s, Standard & Poor’s New York Times, Wall Street Journal, Other Business Publications Risk Management Associates (RMA), Dun & Bradstreet Industry Averages The World Wide Web

Information About Governments 16-18 Information About Governments Government Budget Reports Credit Ratings Assigned to Government Borrowers By Moody’s, Standard & Poor’s, Fitch Web

Lending the Old Fashioned Way? (box) 16-19 Lending the Old Fashioned Way? (box) Traditional Lending Model Deregulation of the 1980s and 1990s New Lending Model Financial Innovations, Such as Securitization, and Their Effect on Lending Mix and Policies (“streamlined” loans) Mortgage Market Problems, 2007 Newer Lending Paradigm or Back to the Basics? An Increased Coordination Among Financial Regulators in Different Countries

Parts of a Typical Loan Agreement 16-20 Parts of a Typical Loan Agreement The Promissory Note Loan Commitment Agreement Collateral Covenants Affirmative Negative Borrower Guaranties and Warranties Events of Default

16-21 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

Loan Review Procedures 16-22 Loan Review Procedures Carrying Out Review of All Types of Loans on a Periodic Basis Structuring the Loan Process Record of Borrower Payments Quality and Condition of Collateral Completeness of Loan Documentation Evaluation of Borrower’s Financial Condition Assessment as to Whether Fits with Lender’s Loan Policies

Loan Review Procedures (cont.) 16-23 Loan Review Procedures (cont.) Reviewing Largest Loans Most Frequently Conducting More Frequent Reviews of Troubled Loans Accelerating the Loan Review Schedule if Economy or Industry Experiences Problems

Warning Signs of Problem Loans 16-24 Warning Signs of Problem Loans Unusual or Unexpected Delays in Receiving Financial Statements Any Sudden Changes in Accounting Methods Restructuring Debt or Eliminating Dividend Payments or Changes in Credit Rating Adverse Changes in the Price of Stock Losses in One or More Years Adverse Changes in Capital Structure Deviations in Actual Sales from Predictions Unexpected and Unexplained Changes in Deposits

16-25 Loan Workouts The Process of Resolving a Troubled Loan So the Bank Can Recover Its Funds

Loan Workout Process Goal is to Maximize Full Recovery of Funds 16-26 Loan Workout Process Goal is to 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 on Possible Options Estimate Resources Available to Collect on Loan Conduct Tax and Litigation Search Evaluate Quality and Competence of Management Consider All Reasonable Alternatives

16-27 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?