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1. BANK LENDING:POLICIES AND PROCEDURES
Department of Finance
San Francisco State University
2. I. TYPES OF BANK LOANS Real estate loans: short-term loans for construction and land development and longer-term loans for the purchase of farmland, homes, apartments, commercial structures, and foreign properties.
Financial institution loans: loans to other banks, insurance companies, finance companies, and other financial institutions.
Agricultural loans: loans to finance farm and ranch operations, mainly to assist in planting and harvesting crops and to support the feeding and care of livestock.
3. I. TYPES OF BANK LOANS 4. Commercial and industrial loans: to businesses to cover expenditures on inventories, paying taxes, and meeting payrolls.
5. Loans to individuals: credit to finance the purchase of automobiles, appliances, and other consumer goods, equity lines for home improvements, and other personal expenses
6. Bank Leasing to corporate firms on equipment or vehicles.
4. I. TYPES OF BANK LOANS TABLE : Loans Outstanding for All U.S. Insured Commercial Banks as of
Percentage of loan Portfolio
Bank Loans Smallest U.S. Largest U.S.
Classified Banks(less Banks(over
by Purpose Amount Percentage than $100 million $1 billion in
($ billions) of Total Loans in total assets) total assets)
1.Total real estate loans
2.Loans for financial institutions
3.Loans to finance agricultural
production and other loans to farmers
4.Commercial and industrial loans
5.Loans to individuals
7.Lease finance receivables
Total (gross) loans shown on
U.S. banks? balance sheet
5. II. Determining the Size and Mix of Bank Loans The characteristics of the market it serves:
The demand for loans by local customers
Local economic conditions.
Bank regulation and capital requirements determines its legal lending limit to a single borrower and the total loan size.
6. II. Factors Determining the Growth and Mix of Bank Loans The bank's official loan principal and policy: The key factor determining the composition of a bank?s loan portfolio.
The loan rates policy by a bank: Borrowers have been shopping around for competitive loans.
7. III. Regulation of Lending Regulations on lending limits:
Banks cannot grant real estate loans by more than the total amount of bank's capital and surplus or 70 percent of its total time and savings deposits, whichever is greater.
A loan to a single customer normally cannot exceed 15 percent of a national bank's capital and surplus account.
8. III. Regulation of Lending Regulation on Equality:
The Community Reinvestment Act (1977) requires banks 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 bank credit.
The Equal Credit Opportunity Act (1974) requires that no individual can be denied credit because of race, sex, religious affiliation, age, or receipt of public assistance.
9. III. Regulation of Lending Regulation on Borrowers? Protection:
The federal Truth-in-Lending Act (1968), require that the household borrower be quoted the "true cost" of a loan, as reflected in the annual percentage interest rate (APR) and all required charges and fees for obtaining credit, before the loan agreement is signed.
10. III. Regulation of Lending Regulation on International Risk Exposure:
The International Lending and Supervision Act requires U .S. banks to report to bank regulatory agencies and make public any credit exposures to a single country that exceed 15 percent of their primary capital or 0.75 percent of their total capital, whichever is the smaller of the two.
This law also imposes restrictions on the fees banks may charge a troubled international borrower to restructure a loan.
11. III. Regulation of Lending Regulation on Bank Rating: The Uniform Financial Institutions Rating System would rate each bank by assigning a numerical rating based on the quality of its asset portfolio:
1 = strong performance.
2 = satisfactory performance.
3 = fair performance.
4 = marginal performance.
5 = unsatisfactory performance.
The higher a bank's asset-quality rating, the less frequently it will be subject to review and examination by federal banking agencies.
12. III. Regulation of Lending The Uniform Financial Institutions Rating System, numerical ratings are also assigned based on examiner judgment of the bank's capital adequacy, management quality, earnings record, liquidity position, and sensitivity to market risk exposure. The CAMELS rating:
Sensitivity to market risk
Banks with an overall rating of 4 or 5-are examined more frequently than the highest-rated banks, those with ratings of 1,2, or 3.
13. IV. Establishing a Loan Policy Important elements of a good bank loan policy as suggested by the Federal Deposit Insurance Corporation:
1. A clear mission statement for the bank's loan portfolio in terms of types, maturities, sizes, and quality of loans.
2. Specification of the lending authority given to each loan officer and loan committee (measuring the maximum amount and types of loan that each person and committee can approve and what signatures are required).
14. IV. Establishing a Loan Policy 3. Lines of responsibility in making assignments and reporting information within the loan department.
4. Operating procedures for soliciting, reviewing, evaluating, and making decisions on customer loan applications.
5. The required documentation that is to accompany each loan application and what must be kept in the bank's credit files (required financial statements, security agreements, etc.).
15. IV. Establishing a Loan Policy 6. Lines of authority within the bank, detailing who is responsible for maintaining and reviewing the bank's credit files.
7. Guidelines for taking, evaluating, and perfecting loan collateral.
8. A presentation of policies and procedures for setting loan interest rates and c fees and the terms for repayment of loans.
9. A statement of quality standards applicable to all loans.
16. IV. Establishing a Loan Policy 10. A statement of the preferred upper limit for total loans outstanding (i.e., the maximum ratio of total loans to total assets allowed).
11. A description of the bank's principal trade area, from which most loans should come.
12. A discussion of the preferred procedures for detecting, analyzing, and working out problem loan situations.
17. V. Steps in the Lending Process 1. Loan requests:
often arise from contacts the bank's loan officers and sales representatives make as they solicit new accounts from individuals and firms operating in the bank's market area.
2. Customers fill out a loan application.
3. An interview with a loan officer.
Interview provides an opportunity for the bank's loan officer to assess the customer's character and sincerity of purpose.
18. V. Steps in the Lending Process 4. Site visits:
If a business or mortgage loan is applied for, a site visit is usually made by an officer of the bank.
5. Credit References:
The loan officer may contact other creditors who have previously loaned money to this customer for credit references.
6. Financial Statements and Documentation
needed for Loan Evaluation, including:
complete financial statements and,
board of directors' resolutions authorizing the negotiation of a loan with the bank.
19. V. Steps in the Lending Process 7. Credit Analysis:
The credit analysis is aimed determining whether the customer has sufficient cash flows and backup assets to repay the loan.
8. Perfecting the Bank?s Claims to Collateral:
To ensure that the bank has immediate access to the collateral or can acquire title to the property involved if the loan agreement is defaulted.
9. Preparing a Loan Agreement:
Once the loan and the proposed collateral are satisfied, the note and other documents that make up a loan agreement are prepared and are signed by all parties to the agreement.
20. V. Steps in the Lending Process 10. Loan Monitoring:
The new agreement must be monitored continuously to ensure that the terms of the loan are being followed and that all required payments of principal and/or interest are being made as promised.
For larger commercial credits, the loan officer will visit the customer's business periodically to check on the firm's progress and to see what other services the customer may need.
21. V. Steps in the Lending Process Usually a loan officer or other staff member places information about a new loan customer in a computer file known as a bank customer profile. This file shows what bank services the customer is currently using and contains other information required by bank management to monitor a customer's progress and financial-service needs.
22. VI. Credit Analysis: The Five Cs Three major questions regarding each loan application must be satisfactorily answered:
1. Is the borrower creditworthy ? How do you know?
2. Can the loan agreement be properly structured and documented so that the bank and its depositors are adequately protected and the customer has a high probability of being able to service the loan without excessive strain?
3. Can the bank perfect its claim against the assets or earnings of the customer so that, in the event of default, bank funds can be recovered rapidly at low cost and with low risk?
23. VI. Credit Analysis: The Five Cs Character:
The loan officer must be convinced that the customer has a well-defined purpose for requesting bank credit and a serious intention to repay.
The loan officer must be sure that the customer requesting credit has the authority to request a loan and the legal standing to sign a binding loan agreement. This customer characteristic is known as the capacity to borrow money. ?
24. VI. Credit Analysis: The Five Cs Cash.
Three sources of income to repay loans:
(a) cash flows generated from sales or income,
(b) the sale or liquidation of assets, or
(c) funds raised by issuing debt or equity securities.
What is cash flow?
Cash flow = Net profits(or total revenue less all expenses) + Non-cash expenses
25. VI. Credit Analysis: The Five Cs Another definition used by some accountants and financial analysts is:
Cash flows = Net profits + Non-cash expenses + Additions to accounts payable - Additions to inventories and accounts receivable.
This latter definition of cash flow is that it helps to focus a bank loan officer's attention on those facets of a customer's business that reflect the quality and experience of its management and the strength of the market the customer serves.
26. VI. Credit Analysis: The Five Cs Collateral:
Does the borrower possess adequate net worth or own enough quality assets to provide adequate support for the loan? The loan officer is particularly sensitive to such features as the age, condition, and degree of specialization of the borrower's assets.
27. VI. Credit Analysis: The Five Cs Conditions:
The loan officer and credit analyst must be aware of recent trends in the borrower's line of work or industry and how changing economic conditions might affect the loan. To assess industry and economic conditions, most banks maintain files of information-newspaper clippings, magazine articles, and research reports-on the industries represented by their major borrowing customers.
28. VI. Credit Analysis: The Five Cs Control:
Control centers on such questions as whether changes in law and regulation could adversely affect the borrower and whether the loan request meets the bank's and the regulatory authorities' standards for loan quality.
29. VII. Structuring and Documenting Loans Structuring a Loan:
Drafting a loan agreement that meets the borrower's need for funds with a comfortable repayment schedule.
Anticipating and accommodating of a customer who may request more or less funds than requested, over a longer or shorter period.
30. VII. Structuring the Loans Imposing certain restrictions (covenants) on the borrower's activities to protect the banks when these activities could threaten the recovery of bank funds.
Specifying the process of recovering the bank's funds - when and where the bank can take action to get its funds returned.
31. VIII. Perfecting the Bank?s Claim on Collateral ?Reasons for Taking Collateral:
The pledge of collateral gives the lender the right to seize and sell those assets designated as loan collateral, using the proceeds of the sale to cover what the borrower did not pay back.
Collateralization of a loan gives the lender a psychological advantage over the borrower. Because specific assets may be at stake, a borrower feels more obligated to work hard to repay his or her loan and avoid losing valuable assets.
32. VIII. Perfecting the Bank?s Claim on Collateral The goal of a bank taking collateral:
To precisely define which borrower assets are subject to seizure and sale and to document for all other creditors to see that the bank has a legal claim to those assets in the event of nonperformance on a loan.
33. VIII. Perfecting the Bank?s Claim on Collateral Common Types of Loan Collateral:
The bank takes a security interest in the form of a stated percentage of the face amount of accounts receivable (sales on credit) shown on a business borrower's balance sheet.
When the borrower's credit customers send in cash to retire their debts, these cash payments are applied to the balance of the borrower's loan.
Two ways to evaluate accounts receivable:
Accounting receivable aging;
Accounting receivable turnover.
34. VIII. Perfecting the Bank?s Claim on Collateral Factoring.
A bank can purchase a borrower's accounts receivable based upon some percentage of their book value.
The borrower's customers are required to send their payments to the purchasing bank.
Usually the borrower promises to set aside funds in order to cover some or all of the losses that the bank may suffer from any unpaid receivables.
35. VIII. Perfecting the Bank?s Claim on Collateral Inventory.
A bank will lend only a percentage of the estimated market value of a borrower's inventory:
Floating Lien: The inventory pledged may be controlled completely by the borrower.
Floor planning: The lender takes temporary ownership of any goods placed in inventory and the borrower sends payments or sales contracts to the lender as the goods are sold.
Ways to evaluate inventory:
Resale of inventory;
Inventory converted to accounts receivable.
36. VIII. Perfecting the Bank?s Claim on Collateral Real Property:
Public notice of a mortgage against real estate is filed with the county courthouse or tax assessor/collector in the county where the property resides.
The bank may also take out title insurance and insist that the borrower purchase insurance to cover damage from floods and other hazards, with the bank receiving first claim on any insurance settlement that is made.
37. VIII. Perfecting the Bank?s Claim on Collateral Approaches to the valuation of real estate:
The Cost approach: the reproduction cost of the building and improvements, deducts estimated depreciation, and adds the value of the land.
Market Data or direct sales comparison approach: estimate the value of the subject property based on the comparable properties? selling prices.
The income approach: the discounted value of the future net operating income streams.
The direct capitalization (?cap? rate) approach: calculate the value by dividing an estimate of its ?stabilized? annual income a factor called ?cap? rate.
38. VIII. Perfecting the Bank?s Claim on Collateral Personal Property:
Banks take a security interest in automobiles, furniture, jewelry, securities, and other forms of personal property owned by a borrower.
A financing statement will be filed publicly in those cases where the borrower keeps possession of any personal property pledged.
A pledge agreement may be prepared if the bank or its agent holds the pledged property, giving the bank the right to control that property until the loan is repaid in full.
39. VIII. Perfecting the Bank?s Claim on Collateral Personal Guarantees:
A pledge of the stock, deposits, or other personal assets held by the major stockholders or owners of a company may be required as collateral to secure a business loan.
Guarantees are often sought by banks in lending to smaller businesses or to firms that have fallen on difficult times. This gives the owners an additional reason to want their firm to prosper and to repay their loan.
40. VX. Sources of Information about Loan Customers RMA publishes many ratios and group them by industry and firm size:
Current assets to current liabilities (the current ratio).
Current assets minus inventories to current liabilities (the quick ratio).
Sales to accounts receivable.
Cost of sales to inventory (the inventory turnover ratio).
Earnings before interest and taxes to total interest payments (the interest coverage ratio).
41. VX. Sources of Information about Loan Customers Fixed assets to net worth.
Total debt to net worth (the leverage ratio).
Profits before taxes to total assets and tangible net worth.
Total sales to net fixed assets and to total assets.
RMA also calculates common-size balance sheets (with all major asset and liability items expressed as a percentage of total assets) and common-size income statements (with profits and operating expense items expressed as a percentage of total sales) for different size groups of firms within an industry.
42. VX. Sources of Information about Loan Customers A Windows-based version of its Annual Statement Studies, called COMPARE2, was developed by RMA. This permits a bank's credit analyst and loan officer to do a spread sheet analysis-arraying the loan customer's financial statements and key financial and operating ratios over time relative to industry averages based upon data from more than 130,000 different businesses.
43. VX. Sources of Information about Loan Customers Standard & Poor's Industry Surveys provides information for analyzing loan applications from business borrowers.
They provide a detailed analysis of recent trends in the borrower's industry and that industry's future outlook. Analysts working for Standard & Poor's examine the prospects for each industry's future sales growth and profitability, the expected impact of technological changes, trends in industry organizational structure and competition, what' s happening to the prices of industry goods and services, and new product developments within each major industrial group where banks make loans.
44. VX. Sources of Information about Loan Customers The Almanac of Business and Industrial Financial Ratios, prepared annually by Dr. Leo Troy, uses Internal Revenue Service data to assemble average operating and financial ratios for firms in different industries and asset-size groups. Twenty-two different ratios are presented for firms grouped by asset size within each industry.
45. VX. Sources of Information about Loan Customers Dun & Bradstreet Credit Services:
This agency collects information on approximately 3 million firms in 800 different business lines. D&B prepares detailed financial reports on individual borrowing companies for its subscribers. For each firm reviewed, the D&B Business Information Reports provide a credit rating, a brief financial and management history of the firm, a summary of recent balance sheet and income and expense statement trends, a listing of any major loans known to be still outstanding against the firm, its terms of trade, the names of its key managers, and the location and condition of the firm's facilities.
46. X. Parts of a Typical Loan Agreement The Note: a written contract to lend to a customers with several different parts. First, there is a note which specifies the principal amount of the loan. The face of the note will also indicate the interest rate attached to the principal amount and the terms under which repayment must take place.
Loan Commitment Agreement. Larger business loans and home mortgage loans often are accompanied by loan commitment agreements, in which 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.
47. X. Parts of a Typical Loan Agreement 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.
Covenants. Most formal loan agreements also contain restrictive covenants, which are usually one of two types: affirmative or negative.
48. X. Parts of a Typical Loan Agreement 1. Affirmative covenants require the borrower to take certain actions, such as periodically filing financial statements with the bank, maintaining insurance coverage on the loan and on any collateral pledged, and maintaining specified levels of liquidity and equity.
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, selling assets, or paying excessive dividends to stockholders.
49. X. Parts of a Typical Loan Agreement Borrower Guaranties or Warranties. In most loan agreements, the borrower specifically guarantees or warranties 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. Whether collateral is posted or not, the loan agreement must identify who or what institution is responsible for the loan and obligated to make payment.
50. X. Parts of a Typical Loan Agreement Events of Default. Finally, most loans contain a section listing events of default, specifying 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.
51. XI. Loan Review 1. Reviewing all types of loans on a periodic basis - every 30, 60, or 90 days on the largest loans, along with a random sample of smaller loans.
2. Detailed the loan review process carefully to include:
a.?The record of borrower payments, to ensure that the customer is not falling behind the planned repayment schedule.
b. The quality and condition of any collateral pledged behind the loan.
52. XI. Loan Review c. The completeness of loan documentation, to make sure the bank has access to any collateral pledged and possesses the full legal authority to take action against the borrower in the courts if necessary.
d. An evaluation of whether the borrower's financial condition and forecasts have changed, which may have increased or decreased the borrower's need for bank credit.
e. An assessment of whether the loan conforms to the bank's lending policies and to the standards applied to its loan portfolio by examiners from the regulatory agencies.
53. XI. Loan Review 3. Reviewing most frequently the largest loans, because default on these credit agreements could seriously affect the bank's own financial condition.
4. Conducting more frequent reviews of troubled loans, with the frequency of review increasing as the problems surrounding any particular loan increase.
5. Accelerating the loan review schedule if the economy slows down or if the industries in which the bank has made a substantial portion of its loans develop significant problems.
54. XII. Handling Problem Loan Situations Common features to problem loans:
1. Unusual or unexplained delays in receiving promised financial reports and payments or in communicating with bank personnel.
2. Sudden changes in methods used by the borrowing firm to account for depreciation, make pension plan contributions, value inventories, account for taxes, or recognize income.
3. For business loans, restructuring outstanding debt or eliminating dividends, or experiencing a change in the customer's credit rating.
55. XII. Handling Problem Loan Situations 4. Adverse changes in the price of a borrowing customer's stock.
5. Net earnings losses in one or more years, especially as measured by returns on the borrower's assets (ROA), or equity capital (ROE), or earnings before interest and taxes (EBIT).
6. Adverse changes in the borrower's capital structure (equity/debt ratio), liquidity (current ratio), or activity levels (e.g., the ratio of sales to inventory).
56. XII. Handling Problem Loan Situations 7. Deviations of actual sales or cash flow from those projected when the loan was requested.
8. Sudden, unexpected, and unexplained changes in deposit balances maintained by the customer.
57. XII. Handling Problem Loan Situations What should a banker do when a loan is in trouble?
1. Always keep the goal of loan workouts firmly in mind: to maximize the bank's chances for the full recovery of its funds.
2. The rapid detection and reporting of any problems with a loan are essential; delay often worsens a problem loan situation.
3. Keep the loan workout responsibility separate from the lending function to avoid possible conflicts of interest for the loan officer.
58. XII. Handling Problem Loan Situations 4. Bank workout specialists should confer with the troubled customer quickly on possible options, especially for cutting expenses, increasing cash flow, and improving management control.
Precede this meeting with a preliminary analysis of the problem and its possible causes, noting any special workout problems.
Develop a preliminary plan of action after determining the bank?s risk exposure and the sufficient of loan documents (especially any claims against the customer?s collateral other than that held by the bank.)
59. XII. Handling Problem Loan Situations 5. Estimate what resources are available to collect the troubled loan (including the estimated liquidation values of assets and deposits).
6. Loan workout personnel should conduct a tax and litigation search to see if the borrower has other unpaid obligations.
7. For business borrowers, bank loan personnel must evaluate the quality, competence, and integrity of current management and visit the site to assess the borrower's property and operations.
60. XII. Handling Problem Loan Situations 8. Bank workout professionals must consider all reasonable alternatives cleaning up the troubled loan, including making a new, temporary agreement if loan problems appear to be short-term in nature or finding a way to help the customer strengthen cash flow (such as reducing expenses or entering new markets) or to infuse new capital into the business. Other possibilities include finding additional collateral, securing endorsements or guarantees, reorganizing, merging or liquidating the firm, or filing a bankruptcy petition.