BANK 404 CREDIT ANALYSIS AND LENDING

1. BANK 404CREDIT ANALYSIS AND LENDING Sathye et all (2003), Chp. 13 PROBLEM LOAN MANAGEMENT

2. Learning Objectives • Outline why loans default • Highlight the extent of problem loans • Explain why the business cycle is important for problem loans • Define problem loans, provisions and regulatory issues

3. Learning Objectives • Discuss the capital issues of problem loans • Define ‘structure dynamic provisioning’ • Restructure problem loans • Illustrate a case from law

4. Introduction • When financial institutions make loans, returns generated mean accepting some default risk • It is imperative that default risk is managed so that the solvency ofthe bank is not threatened • Should the problem loan be foreclosed or actively managed?

5. Causes of Default • Default does not necessarily mean that all of the loan extended is lost. • Default is defined here as ‘a loan where repayments are overdue’ • Better lending procedures can minimise, but not eliminate, the risk of default • Harder to manage default risk as loan book becomes larger

6. Causes of Default • Likely causes of default • Lack of compliance with loan policies • Lack of clear standards and excessivelylax loan terms • Inadequate controls over loan officers • Over-concentration of bank lending • Loan growth exceeding bank’s capabilities • Inadequate problem loan identification • Insufficient knowledge of customer’s finance • Lending in unfamiliar markets

7. Extent of Problem Loans • All banks experience bad debts,but the management of them becomes critical • Banks should consider: • Timing of loan in economic cycle • Larger exposures to individual borrowers • Larger exposures to single sectors • Close monitoring of exposures during unfavourable economic periods

8. The Business Cycle • The business cycle characterised by three phases: • Recovery and Expansion: • Flourishing economy with increased spending leading to higher deposits and interest rates • Boom: • Major asset inflation with business overconfidence and declining credit standards • Downturn: • Declining asset values and economic activity generally accompanied by increased defaults

9. Problem Loans, Provisions and Regulatory Issues • When borrower misses payments, two questions arise within lending institution • Is missed payment temporary? • Is missed payment likely to be permanent?

10. Problem Loans, Provisions and Regulatory Issues • If payment more than 90 days, loan is considered an ‘impaired asset’ as return on loan not achieved • Value of impaired loan must be downgraded on statement of financial position

11. Problem Loans, Provisions and Regulatory Issues • APRA: If one asset is impaired, all loans to that client considered impaired • When loans are impaired, institution must create a ‘provision’ for a loan loss • Provisions are classified in three ways: • Specific Provisions • General Provision • Bad-Debt Write-Offs

12. Problem Loans, Provisions and Regulatory Issues • Specific Provisions: • These are provisions set aside for a specifically identifiable loan where the institution assesses the: • Condition of the loan; • Condition of the borrower; • Impact of economic events. • Not all of the loan must have provisions made as lender may assess the likely losses from the asset.

13. Problem Loans, Provisions and Regulatory Issues • General Provisions • These are provisions that are made as a proportion of the entire loan portfolio • Suitable for large loan portfolios of similar assets, e.g. mortgages, where specific provisioning unsuitable • APRA: Generally minimum provision of 0.5% of Risk-Weighted Assets • Can adjust general provisions level depending on economic activity or risk levels

14. Problem Loans, Provisions and Regulatory Issues • Bad Debts: • Recognition of bad debts occurs where: • All security liquidated; • Guarantees have been enforced; • Remaining remedial actions explored; and • No remaining sources of cash can be called. • Once the above steps are completed, the financial institution must write off the bad debt with asset valued at zero and a charge made against profits.

15. Problem Loans, Provisions and Regulatory Issues • Regulatory Issues: • APRA Guidance Notes AGN 220.1, 220.2 and 220.3 govern bad-debt provisioning • Category 1: Registered first and second mortgages with LVR < 80% have no provision • Category 2: Same as Category 1 but where LVR is between 80% and 100% • Category 3: Same as Categories 1 and 2 but where LVR > 100% (i.e. declining asset values) • Category 4: Covers overdrawn revolving-type facilities where longer default periods produce higher provisioning requirements

16. Other Considerations with Problem Loans • The provisions made minimise the efficient use of capital that could otherwise be used for lending purposes • Institutions often have provisioning systems exceeding APRA requirements to reflect bank’s risk profile • Higher provisions indicate higher risk and/or more conservative management • Lower provisions indicate lower risk and/or more aggressive management

17. Dynamic Provisioning • The risk profile of the loan portfolio is sensitive to point in the economic cycle, e.g. greatest defaults occur at bottom of economic cycle • Therefore: • Credit risk is not static but changes over time • Bad debt should not come as a surpriseas modelling should detect changes to probable default risk in portfolio segments

18. Dynamic Provisioning • Key principles in dynamic provisioning: • Classify loans into homogeneous groups • Sub-classify groups by maturity length • Determine probability of loss for each group • Determine likely severity of loss for each group • Use the historical loan-loss information to create predictive model incorporating economic conditions, interest rates, investment activity, etc. • Apply model outcome to current provisions

19. Dealing with Defaults • If the loan is in default, bank must act to minimise the losses arising from defaulting clients and may reschedule payments rather than liquidate loan • Classify defaulting clients into three categories: • Mild financial distress; • Moderate financial distress; and • Severe financial distress.

20. Dealing with Defaults • Mild Financial Distress • Often occurs when borrower faces short-term cash flow problems, e.g. late receipts • If default less than 90 days, remedies include: • Changing/lengthening repayment schedules • Assisting firm if cash flow shortage has risen from period of rapid growth • Encouraging firm to sell non-core assets • Requesting/demanding equity capital injection

21. Dealing with Defaults • Moderate Financial Distress • May occur if cash flow problems coincide with borrower’s asset values declining • Course of action determined by nature of collateral, e.g. foreclose on mortgage or support manufacturing firm with uniqueor limited market for assets • Lender may consider evaluation of alternatives via NPV or probabilistic model of Expected Values for different actions

22. Dealing with Defaults • Severe Financial Distress • Characterised by missed payments and value of borrower less than loan amount • Lender needs to very carefully evaluate whether is is better to: • Liquidate firm to recover greatest percentageof loan possible; or • Restructure debt (inclusive of debts to other lenders) to maintain operations to allow firm to trade out of current crisis or be sold as going concern

23. Dealing with Defaults • The coordination problem • Where numerous classes of debt-holders observed, e.g. syndicated loans, any rescheduling will require cooperation ofall debt-holders • May be difficult to coordinate actions between junior and senior debt-holders • Need to restructure debts to ensure all debt-holders treated equitably or else rescheduling proposal will fail

24. Dealing with Defaults • Other Breaches • Corporate loans may have a variety of covenants imposed to protect loan quality • Lender may place a variety of conditions to strengthen loan repayment probability: • No excessive withdrawal of cash flows • Risk profile of firm to remain unchanged • Specification of various ratios including gearing, dividend payout and interest coverage • Continued involvement of key staff • Application of risk management strategies

25. Examples from the Law • Winding-up generally performed by registered liquidators who sell assets for the benefit of creditors • State Bank of Victoria relied on collateral of sophisticated rescue equipment stored in barrels. Barrels empty and not worth $250,000 as noted, but only $1,592 each. • Information supplied by Harris Scarfe and HIH Insurance grossly inaccurate and little collateral available when default occurred