1. Lending Policies and Procedures: Managing Credit Risk
Chapter Sixteen
Lending Policies and Procedures: Managing Credit Risk
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2. Key Topics Types of Loans Banks and Competing Lenders Make
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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
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3. 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
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4. Types of Loans Real Estate Loans Financial Institution Loans
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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
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5. 16-5
TABLE 16–1 Loans Outstanding for All FDIC-Insured Banks as of December 31, 2010 (consolidated domestic and foreign offices)
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6. Types of Loans (continued)
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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
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7. 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
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8. Regulation of Lending (continued)
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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 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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9. Regulation of Lending (continued)
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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
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10. Regulation of Lending (continued)
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Regulation of Lending (continued)
Asset Quality
Criticized loans
Scheduled loans
Adversely classified loans
Substandard loans
Doubtful loans
Loss loans
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11. Regulation of Lending (continued)
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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
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12. Regulation of Lending (continued)
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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
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13. Regulation of Lending (continued)
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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.
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14. Steps in the Lending Process
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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 Prospective Customer’s Financial Condition
Assessing Possible Loan Collateral and Signing the Loan Agreement
Monitoring Compliance with the Loan Agreement and Other Customer Service Needs
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15. Credit Analysis: What Makes a Good Loan?
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Credit Analysis: What Makes a Good Loan?
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
Does loan meet written loan policy and how would loan be affected by changing laws and regulations
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16. Credit Analysis: What Makes a Good Loan? (continued)
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Credit Analysis: What Makes a Good Loan? (continued)
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
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17. Credit Analysis: What Makes a Good Loan? (continued)
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Credit Analysis: What Makes a Good Loan? (continued)
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
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18. 16-18
EXHIBIT 16–1 Safety Zones Surrounding Funds Loaned in Order to Protect a Lender
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19. 16-19
TABLE 16–4 Sources of Information Frequently Used in Loan Analysis and Evaluation by Lenders and Loan Committees
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20. Parts of a Typical Loan Agreement
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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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21. 16-21
Loan Review
Carrying out reviews of all types of loans on a periodic basis
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
Reviewing Largest Loans Most Frequently
Conducting More Frequent Reviews of Troubled Loans
Accelerating the Loan Review Schedule if Economy or Industry Experiences Problems
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22. 16-22
Loan Workouts
Loan workout – the process of recovering funds from a problem loan situation
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 projections
Unexpected or unexplained changes in deposits
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23. TABLE 16–5 Warning Signs of Weak Loans and Poor Lending Policies
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TABLE 16–5 Warning Signs of Weak Loans and Poor Lending Policies
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24. Loan Workouts (continued)
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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
Preferred option: Seek a revised loan agreement
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25. 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?
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