1.Lending Policies and Procedures

2. The purpose of this chapter is to : learn about lending policies discuss problem loansTHE PRINCIPAL FUNCTION OF ABANK IS TO MAKE LOANS 3. 16-3 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 4. Real estate loansFinancial institution loansAgriculture loansCommercial and industrial loansLoans to individualsMiscellaneous loansLease financing receivables 5. 16-5 6. Characteristics of market areaLender sizeExperience and expertise of managementExpected yield of each type of loanRegulations 7. Capital adequacyAsset qualityManagement qualityEarnings recordLiquidity positionSensitivity to market risk 8. CriticizedLoansScheduled LoansAdversely Classified Loans Substandard Loans Doubtful Loans Loss Loans 9. Because the quality ofexamination information decaysvery quickly regulators arestarting to use market forces andprivate market discipline tomonitor bank behavior. 10. Goal statement for banks loan portfolio Specification of lending authority of eachloan officer and committee Lines of responsibility in making assignmentsand reporting information Operating procedures for soliciting,evaluating and making loan decisions Required documentation for all loans Lines of authority for maintaining andreviewing credit files 11. Guidelines for taking and perfectingcollateral Procedures for setting loan interest rate Statement of quality standards for all loans Statement of upper limit for total loansoutstanding Description of the banks principal trade area Procedures for detecting, analyzing andworking out problem loans 12. 16-12 Whyis lending so closely regulated by state and federal authorities? Whatis the CAMELS rating, and how is it used? List several elements of a good written loan policy. 13. Findingprospective loan customers Evaluating a customers character andsincerity of purpose Making site visits and evaluating acustomers credit record Evaluating a customers financial record Assessing possible loan collateral andsigning the loan agreement Monitoring compliance with the loanagreement and other customer service needs 14. Character specific purpose of loan and serious intent to repay loanCapacity legal authority to sign binding contractCash ability to generate enough cash to repay loan 15. Collateral adequate assets to support the loanConditions economic conditions faced by borrowerControl does loan meet written loan policy and how would loan be affected by changing laws and regulations 16. AccountsReceivablesFactoringInventoryRealPropertyPersonal PropertyPersonal Guarantees 17. 15-18Problem 16-3Crockett Manufacturing and Service Company holds asizable inventory of dryers and washing machineswhich it hopes to sell to retail dealers over the next sixmonths. These appliances have a total estimatedmarket value currently of $25 million. The firm alsoreports accounts receivable currently amounting to$12,650,000. Under the guidelines for taking collateraldiscussed in this chapter, what is the minimum size loanor credit line Crockett is likely to receive from itsprincipal lender? What is the maximum size loan orcredit line Crockett is likely to receive? 18. 15-19Problem 16-3(continued)Crockett Manufacturing and Service Companyhas an appliance inventory currently valued at$25 million and accounts receivable of $12,650,000. The text says that inventory loanscommonly amount to 30 percent to 80 percentof the inventorys estimated market value andaccount-receivable based loans commonlyamount to 40 to 90 percent of estimatedmarket value. 19. 15-20 Problem 16-3(continued)These figures suggest that the minimum size credit line available would be:0.30 x $25,000,000 + 0. 40 x $12,650,000 = $7,500,000 + $5,060,000= $12,560,000.The maximum sized credit line available would be: 0.80 x $25,000,000 + 0.90 x $ 12,650,000= $20,000,000+ 11,385,000 = $31,385,000 20. Spreadsheet AnalysisRatios Current ratioInventory turnover ratio Quick ratioLeverage ratioCommon-sizeincome statement and balance sheetSources of industry information RMA COMPARE2 Dun & Bradstreet MoodysS&P 21. Consumer-supplied financial statementsCredit bureau reportsExperience of other lendersVerification of employmentVerification of property ownershipThe web 22. Financial reports supplied by the borrowingfirm Copies of board of directors resolutions orpartnership agreements Credit ratings Dun & Bradstreet, Moodys,Standard & Poors New York Times, Wall Street Journal, otherbusiness publications Risk Management Associates, Dun &Bradstreet industry averages Web 23. Government Budget reportsCreditRatings assigned to government borrowers by Moodys, Standard & Poors, FitchWeb 24. The Promissory NoteLoan Commitment AgreementCollateralCovenants Affirmative NegativeBorrowerGuaranties and WarrantiesEvents of Default 25. Examinationof outstandingloans to make sure borrowersare adhering to their creditagreements and the bank isfollowing its own loanpolicies 26. 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 borrowers financialcondition Assessment as to whether fits withlenders loan policies 27. Reviewing largest loans most frequentlyConducting more frequent reviews of troubled loansAccelerating the loan review schedule if economy or industry experiences problems 28. Unusual or unexpected delays in receiving financialstatements Any sudden changes in accounting methods Restructuring debt or eliminating dividendpayments 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 29. The process of resolving atroubled loan so the bank canrecover its funds 30. Goalis to maximize full recovery of funds Rapid detection and reporting of problems isessential Loan workout should be separate from lendingfunction Should consult with customer quickly onpossible options Estimate resources available to collect on loan Conduct tax and litigation search Evaluate quality and competence of management Consider all reasonable alternatives 31. 16-32 What three major questions or issuesmust a lender consider in evaluatingnearly all loan requests? Explain the following terms: character,capacity, cash, collateral, conditions, andcontrol. 32. 16-33Quick Quiz What are the principal parts of a loanagreement? What is each part designedto do? What are some warning signs tomanagement that a problem loan maybe developing?McGraw-Hill/Irwin 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.Bank Management and Financial Services, 6/e 33. Makingloans is principal economic function ofbanks Lending is risky Written loan policy CAMELS and Six Cs of credit Credit analysis Normalize income statement and balance sheet Credit worthiness of borrower Structure of loan agreement Perfect of claim on borrower Loan review process Problem loan workout 34. 15-35Problem 16-2Aspiration Corporation, seeking renewal of its$12 million credit line, reports the data in thefollowing table (in millions of dollar) to HotSprings National Banks loan department.Please calculate the firms cash flow as definedearlier in this chapter. What trends do youobserve and what are their implications for thedecision to renew or not renew the firms creditline? 35. 15-36 Problem 16-2 (continued)Proj. for 20X1 20X2 20X3 20X4 NextYrSales Revenue 7.9 8.4 8.8 9.5 9.9Costs of Goods Sold$5.1 $5.5 $5.7 $6.0 $6.4Selling and Admin Exp.8.0 8.2 8.3 8.6 8.9Depreciation and othernoncash expenses 11.2 11.2 11.1 11.0 10.9Taxes Paid in Cash4.4 4.6 4.9 4.1 3.6 36. 15-37Problem 16-2 (continued) Cash Flow = Sales Revenues Cost of Goods Sold Selling andAdmin Taxes Paid in Cash + Non Cash Expenses 20x1 $7.9 - $5.1 - $8.0 - $4.4 + $11.2 = $1.6 million 20x2 $8.4 - $5.5 - $8.2 $4.6 + $11.2 = $1.3 million 20x3 $8.8 - $5.7 - $8.3 - $4.9 + $11.1 = $1.0 million 20x4 $9.5 - $6.0 - $8.6 - $4.1 + $11.0 = $1.8 million Next $9.9 - $6.4 - $8.9 - $3.6 + $10.9 = $1.9 millionYear Proj. for 20X1 20X2 20X3 20X4 Next Yr Cash Flow Estimate $1.6 $1.3 $1.0 $1.8 $1.9 37. 15-38 Problem 16-2 (continued)While this firm had an initial decrease in cashflows, in the last year its cash flows haverebounded significantly, suggesting that the firmwould have less trouble making required loanpayments. The lender needs to be sure to check tosee if the projections for next year seemreasonable. Borrowers are sometimes overoptimistic about future opportunities. However, ifthe projections are reasonable, Hot SpringsNational Bank should consider renewing the loan.