LENDING POLICIES AND PROCEDURES: MANAGING CREDIT RISK

Chapter 16 - Lending Policies and Procedures: Managing Credit Risk

CHAPTER 1 LENDING POLICIES AND PROCEDURES: MANAGING CREDIT RISK

Goal of This Chapter: The purpose of this chapter is to learn why sound lending policies are important to banks and other lenders and the public they serve and how to spot and deal with problem loans when they appear in an institution’s portfolio. Key Topics in This Chapter      

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 Chapter Outline

I. Introduction II. Types of Loans A. Types of Loans: 1. Real Estate Loans 2. Financial Institutions Loans 3. Agricultural Loans 4. Commercial and Industrial Loans 5. Loans to Individuals 6. Miscellaneous Loans 7. Lease Financing Receivables B. Factors Determining the Growth and Mix of Loans 1. Characteristics of the Market Area 2. Loan Participations 3. Lender Size 4. Experience and Expertise of Management 5. Institution's Loan Policy 6. Expected Yield 7. Functional Cost Analysis

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Chapter 16 - Lending Policies and Procedures: Managing Credit Risk

III. Regulation of Lending A. Relevant Regulations: 1. The Lending Limit 2. Limitation on Real Estate Lending 3. The Community Reinvestment Act (1977) 4. Equal Credit Opportunity Act (1974) 5. Truth-in-Lending Act 6. International Lending Rules 7. Examiner Loan Ratings 8. CAMELS Rating B. Establishing A Written Loan Policy IV. Steps in the Lending Process 1. Finding Prospective Loan Customers 2. Evaluating a Prospective Customer’s Character and Sincerity of Purpose 3. Making Site Visits and Evaluating a Prospective Customer’s Credit Record 4. Evaluating a Prospective Customer’s Financial Condition 5. Assessing Possible Loan Collateral and Signing the Loan Agreement 6. Monitoring Compliance with the Loan Agreement and Other Customer Service Needs V. Credit Analysis: What Makes a Good Loan? A. Is the Borrower Creditworthy? The Cs of Credit 1. Character 2. Capacity 3. Cash 4. Collateral 5. Conditions 6. Control B. Can the Loan Agreement Be Properly Structured and Documented? C. Can the Lender Perfect Its Claim Against the Borrower's Earnings and Any Assets That May Be Pledged as Collateral? 1. Reasons for Taking Collateral 2. Common Types of Loan Collateral a. Accounts Receivable b. Factoring c. Inventory d. Real Property e. Personal Property f. Personal Guarantees 3. Other Safety Devices to Protect a Loan VI. Sources of Information About Loan Customers A. Credit Bureaus B. Publications of Financial Information C. Information on Economic Conditions

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Chapter 16 - Lending Policies and Procedures: Managing Credit Risk

VII. Parts of A Typical Loan Agreement A. The Promissory Note B. Loan Commitment Agreement C. Collateral D. Covenants (Affirmative and Negative) E. Borrower Guaranties or Warranties F. Events of Default VIII. Loan Review A. The Purpose of Loan Review B. Elements of a Good Loan Review IX. Loan Workouts A. Signs of a Developing Problem Loan Situation B. Steps in Maximizing the Recovery of Funds from a Problem Loan (the Loan Workout Problem) X. Summary of the Chapter Concept Checks 16-1. In what ways does the lending function affect the economy of its community or region? Bank credit is one of the most important sources of capital that fuels local economic growth and development. When banks make loans to support the development of new businesses and to aid the growth of existing businesses, new jobs are created and there is a greater flow of income and spending throughout the local economy. 16-2. What are the principal types of loans made by banks? Bank loans are usually classified by the purpose of the loans. The most common classifications are real estate loans, commercial and industrial loans, loans to financial institutions, credit-card and other loans to individuals, lease financing, and agricultural production loans. Bank loans may also be classified by maturity - over one year and one year or less. 16-3. What factors appear to influence the growth and mix of loans held by a lending institution? The particular mix of any lending institution's loan portfolio is shaped by the characteristics of its market area, the expected yield and cost associated with each type of loan, loan participations, bank size, the experience and expertise of management, and the institution’s written loan policy and regulations.

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Chapter 16 - Lending Policies and Procedures: Managing Credit Risk

16-4 A lender's cost accounting system reveals that its losses on real estate loans average 0.45 percent of loan volume and its operating expenses from making these loans average 1.85 percent of loan volume. If the gross yield on real estate loans is currently 8.80 percent, what is this lender's net yield on these loans? The bank's net yield on real estate loans must be: Net Yield on Real Estate Loans = 8.80% - 0.45% - 1.85% = 6.50% 16-5. Why is lending so closely regulated by state and federal authorities? Lending is closely regulated because it is the center of risk for most lending institutions. Lending institutions in the U.S. are limited in the loans they can make to a single borrower by the size of their capital and surplus. They also must limit their real estate loans based on the size of their total time and savings deposits or capital. Discrimination against borrowers on the basis of their age, sex, religion, or national origin is prohibited by U.S. law. They also cannot discriminate against borrowers from certain neighborhoods in their service areas. Any loans made are subject to examination and review and many are restricted or even prohibited by law. 16-6. What is the CAMELS rating and how is it used? The CAMELS rating is a system used by federal bank examiners for evaluating the overall condition of a bank based upon the adequacy of its capital, the quality of its asset portfolio, its management quality, the adequacy of its earnings, its liquidity position and its sensitivity to market risk. 16-7. What should a good written loan policy contain? A good written bank loan policy should specify the goals of the loan portfolio and program, describe an ideal loan portfolio for the institution and indicate the types of loans they normally will refuse to make, specify who has the authority to approve loans of varying type and size, the documentation requirements of different types of loans, and supply guidelines on loan pricing and collateralization for loan officers. Lines of responsibility in making assignments and reporting information, operating procedures for soliciting, evaluating, and making decisions on customer loan applications, and the required documentation that is to accompany each loan application and what must be kept in the lender’s files, lines of authority detailing who is responsible for maintaining and reviewing the institution’s credit files, guidelines for taking, evaluating, and perfecting loan collateral, procedures for setting loan rates and fees and the terms for repayment of loans, and a statement of quality standards applicable to all loans, statement of the preferred upper limit for total loans outstanding, description of the lending institution’s principal trade area, from which most loans should come, procedures for detecting and working out problem loan situations.

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Chapter 16 - Lending Policies and Procedures: Managing Credit Risk

16-8. What are the typical steps followed in receiving a loan request from a customer? A loan officer usually takes or receives such a request initially and passes it along to the credit analysis division for technical review. Usually the recommendations of both the credit analyst and the loan officer are directed to a loan supervisor or loan committee for approval. 16-9. What three major questions or issues must a lender consider in evaluating nearly all loan requests? The three key issues with every loan: 1. Is the borrower creditworthy? 2. Can the loan agreement be properly structured and documented? 3. Can the lender perfect its claim against the borrower's earnings and any assets that may be pledged as collateral? 16-10. Explain the meaning of the following terms: character, capacity, cash, collateral, conditions, and control? a. Character -- is the borrower specific about the purpose of a loan and has a serious intent to repay? b. Capacity -- does the borrower have the legal authority to sign and commit to a binding loan agreement? c. Capital -- does the borrower generate sufficient income or cash flow to properly service a loan? d. Collateral -- does the borrower possess assets of sufficient quality and value to backstop a loan? e. Conditions -- does the outlook for the economy and industry where a borrower is situated add strength to a loan? f. Control -- does the proposed loan meet the bank's own quality standards and the standards of bank examiners?

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Chapter 16 - Lending Policies and Procedures: Managing Credit Risk

16-11. Suppose a business borrower projects that it will experience net profits of $2.1 million, compared to $2.7 million the previous year and will record depreciation and other noncash expenses amounted of $0.7 million this year versus $0.6 million last year. What is this firm’s projected cash flow for this year? Is the firm’s cash flow rising or falling? What are the implications for a lending institution thinking of loaning money to this firm? Suppose sales revenue rises by $0.5 million, costs of goods sold decreases by $0.3 million, while cash tax payments increase by $0.1 million and noncash expenses decrease by $0.2 million. What happens to the firm’s cash flow? What would the lender’s likely reaction to these events? The firm's projected cash flow can be estimated by either of two methods discussed in the text: Cash Flow Estimate B = $2.1 million + $0.7 million = $2.8 million for the Current Year The previous year the cash flows amounted to: Cash Flow Estimate B = $2.7 million + $0.6 million = $3.3 million For the Previous Year Clearly the firm's cash flow is falling, which suggests that the lending institution needs to find out the reasons for this decline before committing any of funds. Sales Revenue Costs of Goods Sold Cash Tax Payments Noncash Expenses Total

+$.5 +$.3 -$.1 -$.2 +$0.5 increase in cash flows from these changes

These changes should make the lender happier because it means that cash flows are rising again. 16-12. What sources of information are available today that loan officers and credit analysts can use in evaluating a customer loan application? Among the most widely used sources of information used in evaluating loans are financial statements supplied by the borrower and industry-wide performance ratios for comparison purposes supplied by such organizations as Dun and Bradstreet and Risk Management Associates (RMA). To exchange credit information among business lending institutions and to organize conferences and publish educational materials to help train loan officers and credit analysts.

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Chapter 16 - Lending Policies and Procedures: Managing Credit Risk

16-13. What are the principal parts of a loan agreement? What is each part designed to do? The most important parts of loan agreements include a signed note which specifies the interest rate and the terms of the loan, a listing of covenants which specify what the borrower must and must not do, documents specifying loan collateral which protects the lender’s interests, and a section describing what events or happenings will trigger default. 16-14. What is loan review? How should a loan review be conducted? Loan review is a process of periodic investigation of outstanding loans on an institution's books to make sure each loan is paying out as planned, all necessary documentation is present, and the bank's loan officers are following the institution's loan policy. While lending institutions today use a variety of different loan review procedures, a few general procedures are followed by nearly all lending institutions. These include: 1. Carrying out reviews of all types of loans on a periodic basis. 2. Structuring the loan review process carefully to make sure the most important features of each loan are checked. 3. Reviewing the largest loans most frequently. 4. Conducting more frequent reviews of troubled loans. 5. Accelerating the loan review schedule if the economy slows down or if industries in which the bank has made a substantial portion of its loans develop significant problems. Loan review is not a luxury but a necessity for a sound lending program. It not only helps management spot problem loans more quickly but also acts as a continuing check on whether loan officers are adhering to a bank's loan policy. For this reason, as well as to promote objectivity in the loan review process, many of the largest institutions separate their loan review personnel from the loan department itself. Loan reviews also aid senior management and the bank's board of directors in assessing the overall exposure to risk and its possible need for more capital in the future. 16-15. What are some warning signs to management that a problem loan may be developing? Problem loans are often characterized by reduced communication between borrower and lender, delays in receiving financial reports, evidence of reevaluations of assets (such as inventory or pension-plan assets), declining stock prices, changes in management, or the restructuring of other loans the borrower has taken out.

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Chapter 16 - Lending Policies and Procedures: Managing Credit Risk

16-16. What steps should a lender go through in trying to resolve a problem loan situation? The most important first step is to move quickly to contact the borrower, to ascertain if the borrower understands the nature of the loan problem, to explore for creative solutions to the problem, and to get the borrower to reach a decision on the best solution possible. Problems & Projects 16-1. The lending function of depository institutions is highly regulated and this chapter gives some examples of the structure of these regulations for national banks. In this problem you are asked to apply those regulations to Tree Rose National Bank (TRNB). Tea Rose has the following sources of funds: $250 million in capital and surplus, $200 million in demand deposits, $775 million in time and savings deposits, and $200 million in subordinated debt. a. What is the maximum dollar amount of real estate loans that TRNB can grant? TRNB can grant ($775)*70% = $542.50 million in real estate loans b. What is the maximum dollar amount TRNB may lend to a single customer? TRNB may lend up to $250*15% = $37.50 million to a single customer. 16-2. Aspiration Corporation, seeking renewal of its $12 million credit line, reports the data in the following table (in millions of dollar) to Hot Springs National Bank’s loan department. Please calculate the firm’s cash flow as defined earlier in this chapter. What trends do you observe, and what are their implications for the decision to renew or not renew the firm’s line of credit?

Costs of Goods Sold Selling and Admin Exp. Sales Revenue Depreciation and other noncash expenses Taxes Paid in Cash

Next 20X1 20X2 20X3 20X4 Year $5.1 $5.5 $5.7 $6.0 $6.4 $8.0 $7.9

$8.2 $8.4

$8.3 $8.8

$8.6 $9.5

$8.9 $9.9

$11.2 $11.2 $11.1 $11.0 $10.9 $4.4 $4.6 $4.9 $4.1 $3.6

Cash Flow = Sales Revenues – Cost of Goods Sold – Selling and Admin – Taxes Paid in Cash + Non Cash Expenses

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Chapter 16 - Lending Policies and Procedures: Managing Credit Risk

20x1 20x2 20x3 20x4 Next Year

$7.9 - $5.1 - $8.0 - $4.4 + $11.2 = $1.6 million $8.4 - $5.5 - $8.2 – $4.6 + $11.2 = $1.3 million $8.8 - $5.7 - $8.3 - $4.9 + $11.1 = $1.0 million $9.5 - $6.0 - $8.6 - $4.1 + $11.0 = $1.8 million $9.9 - $6.4 - $8.9 - $3.6 + $10.9 = $1.9 million

While this firm had an initial decrease in cash flows, in the last year its cash flows have rebounded significantly, suggesting that the firm would have less trouble making required loan payments. The lender needs to be sure to check to see if the projections for next year seem reasonable. Borrowers are sometimes over optimistic about future opportunities. However, if the projections are reasonable, Hot Springs National Bank should consider renewing the loan. 16-3. Crockett Manufacturing and Service Company holds a sizeable inventory of dryers and washing machines, which it hopes to sell retail dealers over the next six months. These appliances have a total estimated market value currently of $25 million. The firm also reports accounts receivable currently amounting to $12,650,000. Under the guidelines for taking collateral discussed in this chapter, what is the minimum size loan or credit line Crockett is likely to receive from its principal lender? What is the maximum size loan or credit line Crockett is likely to receive? These figures suggest that the minimum size credit line available would be: Minimum-Size Credit Line Available = 0.30 x $25,000,000 + 0.40 x $12,650,000 = $7,500,000 + $5,060,000 = $12,560,000. Maximum-Size Credit Line Available = 0.80 x $25,000,000 + 0.90 x $12,650,000 = $20,000,000 + $11,385,000 = $31,385,000 16-4. Under which of the six Cs of credit discussed in this chapter does each of the following pieces of information belong? The particular C of credit represented by each piece of information presented in this problem was as follows: a. First National Bank discovers there is already a lien against the fixed assets of one of its customers asking for a loan. Collateral b. Xron Corporation has asked for a type of loan its lender normally refuses to make. Control

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Chapter 16 - Lending Policies and Procedures: Managing Credit Risk

c. John Selman has an excellent credit rating. Character d. Smithe Manufacturing Company has achieved higher earnings each year for the past six years. Cash e. Consumers Savings Association’s auto loan officer asks a prospective customer, Harold Ikels, for his driver’s license. Capacity f. Merchants Center National Bank is concerned about extending a loan for another year to Corrin Motors because a recession is predicted in the economy. Conditions g. Wes Velman needs an immediate cash loan and has gotten his brother, Charles, to volunteer to cosign the note should the loan be approved. Character h. ABC Finance Company checks out Mary Earl’s estimate of her monthly take home pay with Mary’s employer, Bryan Sims Doors and Windows. Cash i. Hillsoro Bank and Trust would like to make a loan to Pen-Tab Oil and Gas Company but fears a long-term decline in oil and gas prices. Conditions j. First State Bank of Jackson seeks the opinion of an expert on the economic outlook in Mexico before granting a loan to a Mexican manufacturer of auto parts. Control k. The history of Membres Manufacture and Distributing Company indicates the firm has been through several recent changes of ownership and there has been a substantial shift in its principal suppliers and customers in recent years. Capacity l. Home and Office Savings Bank has decided to review the insurance coverages maintained by its borrowing customer, Plainsman Wholesale Distributors. Collateral

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Chapter 16 - Lending Policies and Procedures: Managing Credit Risk

16-5. Butell Manufacturing has an outstanding $11 million loan with Citicenter Bank for the current year. As required in the loan agreement, Butell reports selected data items to the bank each month. Based on the following information, is there any indication of a developing problem loan? About what dimensions of the firm’s performance should Citicenter Bank be concerned?

Butell has announced within the past 30 days that it is switching to new methods for calculating depreciation of its fixed assets and for valuing inventories. The firm’s board of directors is planning to discuss at its next meeting a proposal to reduce stock dividends in the coming year. Selected items reported to the bank by the company do indicate the possible development of a problem loan situation. For one thing, Butell's cash account has fallen sharply in the latest month after several months of a substantial uptrend and the firm's liquidity ratio of current assets to current liabilities has declined significantly in the last 3 months. Decreases in the firm's liquidity position may be signaling declining sales and/or difficulty in maintaining enough cash to meet near-term liabilities. Another possible cause for concern centers around Butell's capital structure as its ratio of equity capital relative to debt financing is falling, indicating that creditors (including Citicenter Bank) are providing a larger share of the firm's capitalization. Thus, each creditor is becoming less well secured. However, these changes in liquidity and capital structure may only reflect normal seasonal pressures and may not be real problems for the bank, especially because other aspects of Butell's recent performance--its stock price, earnings before interest and taxes, and ROA seem to be improving.

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Chapter 16 - Lending Policies and Procedures: Managing Credit Risk

Perhaps of greater moment is the decline of sales revenue below Butell's projections. As of the latest month sales revenue reached $290 million versus a projection of $298 million. Citicenter Bank must determine the causes of this sales shortfall to see if the firm is encountering increasing resistance to sales of its product lines. However, even this trend may not be cause for alarm because sales may be so volatile in Butell's industry that few analysts put any faith in sales projections. The bank's loan officer needs to review the customer's earlier sales projections and sales revenue to determine if there is a real cause for concern. Butell has indicated a recent switch in inventory and depreciation accounting methods. Citicenter's loan officer would do well to inquire into the reasons for these changes because they may reflect an attempt by the firm to offset actual or potential future losses in some aspect of its operations. 16-6. Identify which of the following loan covenants are affirmative and which are negative covenants? a. Nige Trading Corporation must pay no dividends to its shareholders above $3 per share without express lender approval. Restrictions on payment of dividends represent negative loan covenants. b. HoneySmith Company pledges to fully insure its production line equipment against loss due to fire, theft, or adverse weather. A requirement to insure selected assets is an affirmative loan covenant. c. Soft-Tech Industries cannot take on new debt without notifying its principal lending institution first. Restrictions against taking on new debt represent negative loan covenants. d. PennCost Manufacturing must file comprehensive financial statements each month with its principal bank. The requirement 6f filing periodic financial statements with the bank is an affirmative loan covenant. e. Dolbe King Company must secure lender approval prior to increasing its stock of fixed assets. A requirement of securing bank approval before adding to a borrower's stock of fixed assets is considered a negative loan covenant. f. Crestwin Service Industries must keep a minimum current (liquidity) ratio of 1.5 under the terms of its loan agreement. Requiring a borrowing customer to maintain a current ratio -- a liquidity measure --no lower than 1 .5x is an affirmative loan covenant.

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Chapter 16 - Lending Policies and Procedures: Managing Credit Risk

g. Dew Dairy Products is considering approaching Selwin Farm Transport Company about a possible merger but must first receive lender approval. The stipulation that prior bank approval of a proposed merger must be obtained is a negative loan covenant. 16-7. Please identify which of the basic Cs of lending — character, capacity, cash, collateral, conditions, and control —applies to each of the loan factors listed here:

The particular C of lending which applies to each loan factor is listed below:

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Chapter 16 - Lending Policies and Procedures: Managing Credit Risk

Character Credit rating

Capacity Corporate resolution

Cash Liquid reserves

Collateral Insurance coverage

Experience of other lenders Purpose of loan

Driver’s license Social security card

Expense controls Inventory turnover

Payment record

History of firm

Projected cash flows

Asset specialization Guarantees and warrantees Asset liquidation

Customer identity Partnership agreement

Price earnings ratio Coverage ratios Management quality Leverage

Changes in technology Obsolescence Liens Future financing needs

Accounts Receivables Turnover Accounts Payable Turnover

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Conditions Competitive climate for customers product Expected market share Business cycle

Control Adequate documentation

Written loan policy Changes in accounting standards Performance Laws and of comparable regulations that firms apply to the making of loans Industry outlook Inflation outlook Wages in the labor market Economists’ Forecasts