Credit and its Inherent Risks PDF

Unit 1 Credit and its Inherent Risks Overview Most financial experts including bankers believe that the defining business of banking is lending or credit. While the conventional scope of bank credit is changing, this view is confirmed by international da...

Unit 1 Credit and its Inherent Risks Overview Most financial experts including bankers believe that the defining business of banking is lending or credit. While the conventional scope of bank credit is changing, this view is confirmed by international data on banking. For example, over $1 trillion in bank loans are currently outstanding according to the Bank for International Settlements. Interest and fees on loans contribute approximately two-thirds of banks total operating income. What is meant by the term credit? What role does it play in the economy? How does the credit function operate in financial institutions? What is credit analysis and what purpose does it serve? What are the benefits of having a credit policy? These are some of the questions which we will be addressing in this introductory session to set the framework for the more detailed studies later in the course. Our studies will focus primarily on the credit function in financial institutions, so we will begin by looking at how banks operate in general and how the credit function is administered. There are two sessions in this unit: Session 1.1: Credit and Its Inherent Risks Session 1.2: Cannons of Good Lending and the Basic Principles of Sound Lending Practice MGMT3081 - UNIT 1 1  Unit 1 Learning Objectives At the end of this unit you will be able to: 1. Identify the key terms related to credit/lending 2. Explain the role of credit 3. Explain the inherent risks associated with credit/lending 4. Explain the basic principles of lending 5. Explain strategies to mitigate against losses arising from the inherent risks associated with credit 6. Explain the importance of a credit policy and the various clauses it may contain 7. Introduce and explain the basic principles of lending or granting credit 8. Explain a formalized approach for the assessment of lending proposals. Please note that for the purpose of this course, we will be using the terms credit and lending interchangeably. Online Resources/Readings Banking 1 http://www.youtube.com/watch?v=E-HOz8T6tAo Borbora, R. R. (2008). General Principles of Lending http://cab.org.in/Lists/Knowledge%20Bank/DispForm.aspx?ID=2 Dennis, M. C. (2004). Credit Policy and Procedure Manual http://www.coveringcredit. com/business_credit_articles/Credit_Policies/art585.shtml Shuaib, Y. A. (2001). Basic Principles of Bank Lending. http: //www.yashuaib.com/ banklending.htm 2 MGMT3081 Credit Analysis and Lending Session 1.1 Credit and Its Inherent Risks Introduction Lending or credit granting is a primary function of financial institutions. It accounts for a vast portion of the revenue stream of these businesses and in some cases, a major part of expenses. The lending function can make a financial institution and in the same breath, can break it. The deciding factor is the quality of credit and the administration/monitoring of credit to ensure timely repayments in accordance with credit agreement. Bank lending activities are important for three reasons. First is the bank’s responsibility to meet the legitimate needs of the community. Second, client relationships are established and strengthened by lending funds to creditworthy borrowers. In addition, lending programs facilitate cross selling of other banking services. Third earnings from lending activities are the primary source of bank revenues. Earnings from loans come from three sources: loan interest, fee income, and investment income from new deposits. J. Paul Getty once the world’s richest man, observed: “if you owe the bank $100, that’s your problem. If you the bank a $100 million that’s the bank’s problem.” To be certain lending to businesses, governments and individuals is one of the most important services banks/ financial institutions and their competitors provide, and it is also among the riskiest as the most recent credit crisis (the subprime debacle) has demonstrated. However, risky or not one of the main reasons banks are given licences is to make loans to their customers. Bankers usually talk about inherent risk. This is because of the fact that risk may exist in the business of lending whether it is recognized or not. So, inherent risk is usually defined as the likelihood of loss that may exist in each line of business activity without consideration of the level of management control in place. These may include but not limited to: Inherent risk resulting from business choices (e.g. originating or buying subprime mortgage loans); Inherent risk level that may change with changes in the economy and other non- controllable factors (e.g., check fraud increases, bank robberies increase, mortgage defaults increase); A high degree of inherent risk which may not necessarily be negative, nor is having a low level of inherent risk necessarily positive; The Bank’s strategic business objectives help may determine what is an acceptable level of inherent risk; and MGMT3081 - UNIT 1 3  The level of inherent risk implies the risk strategies to be employed, and controls and monitoring procedures to be used (e.g., riskier approaches need more monitoring and more control). Key Terms Before going further, let us pause to grapple with the definition for some key terms. I expect that you would be familiar with most of these terms, but we need to set these out to ensure that we have a common understanding. Credit − A deferred payment arrangement where a benefit is received now and paid for at an agreed future date. Secured credit − A credit arrangement which specifies an alternative in the event of default Unsecured credit − A credit arrangement which does not identify any alternative in the event of default Collateral − Alternative asset which is specified to be ceased and its value realised in event of default or other breach of loan covenants Risk - in a lending context is the likelihood of loss arising from the customers’ inability to pay the loan. That is, the source of repayment breaking down. Credit Risk (also known as default risk) − The probability that the borrower will not meet agreed debt obligations Credit Policy − Clear, written guidelines that set the terms and conditions for providing credit, customer qualification criteria, procedure for making collections, and steps to be taken in case of customer delinquency. Default Risk - involves inability or unwillingness of a customer or borrower to meet commitments or obligations in relation to lending, trading, settlement and other financial transactions. It represents the risk to earnings and capital that the obligor or borrower may fail to meet the terms of any contract with the bank or other financial institution. Inherent risk - Usually defined as the risk that exists in each line of business without consideration of the level of management control in place. Securitization – The setting aside of a group income-earning assets and issuing securities against them. It is the issuance of a debt instrument in which the promised payments are derived from revenues generated by a defined pool of loans. The pool includes mortgages loans, credit card loan, car loans and loans to businesses. Commercial Paper – Short-term unsecured IOU’s offered to investors in the money market by major corporations with the strongest credit ratings. 4 MGMT3081 Credit Analysis and Lending  Learning Activity 1.1 Discussion Forum Investigate the country of origin of two major commercial banks in your country. Review the definition of the terms as given in the section on key terms. 1. Are there any differences in the way the two banks you have identified define these terms? 2. Can these differences be explained by differences in culture? 3. Discuss your responses with your classmates and support your position with research evidence where possible. The Role of Credit Credit is a common place occurrence in our lives to the extent that it is difficult not to be a participant in some credit transaction or the other. Why is this so? Why do consumers use credit? Why do lenders give credit? How does credit affect the economy? The role of lending is to ensure that both the consumer and lender benefit from the proposed transaction. Successful lending or granting of credit is about getting the balance correct between the financial return the lender expects to receive and the risk that the borrowing may not be repaid as anticipated. Above all there is need for the bank to obtain more lending / credit business against the risk of the proposition put to it. The bank’s attitude to risk may vary from time to time usually in line general economic conditions so that the lender must be guided by the policies and guidelines of the bank. To some extent lending money is a matter of common sense, but in addition to that, if bank officers are to succeed as lending bankers they need to adopt a formalized approach to lending so that they do not miss anything which is essential. First let us look at the consumer. Credit allows the borrower to make immediate purchases without the need to utilize their resources immediately but instead to draw down on their resources over a period of time in the future or at a specified date to meet their obligation for the purchase. Credit increases the current purchasing power of consumers- they can buy now and pay later. In doing so they are then able to deploy their resources to other activities – they enjoy greater spending power in the present. They can buy things now which they would not have been able to do without credit, and can take advantage of opportunities for savings, for example, promotional sales and bulk purchases that they may otherwise not have been able to. MGMT3081 - UNIT 1 5  Next, let us look at the lender. Credit is available from financial institutions or various business partners. Financial institutions offer credit as a service from which they earn revenue by charging interest and fees. Businesses offer credit terms to their customers to facilitate immediate sales. Credit can be a product in itself or it can be an enabler for sales. Credit facilitates trading and commercial transactions in general; it stimulates economic activities. Credit is therefore also used as a fiscal tool by government for managing the economy. Government intervenes to make it attractive to borrow in an attempt to stimulate demand and by extension, production to satisfy the increased demand, resulting in improvement in the economic indicators for the country, for example, increased Gross Domestic Product, increased employment etc. Conversely, government may make it unattractive to borrow in an effort to contract economic activities especially in cases where production cannot keep pace with demand resulting in high inflation rates as too much money chases too few goods. We will now look at how credit works in the banking system. It is important to note that banks can only lend what is deposited with them. Any bank that created deposits in excess of the funds deposited with it souls quickly find it cannot meet the demand of depositors for cash. Because of this, it is sometimes said that banks cannot create deposits; they simply lend funds that are deposited with them. Nevertheless any deposit of cash received by a single bank will create the potential for a multiple increase in the volume of bank deposits by the banking system as a whole. To explain the multiple expansion of deposits consider a simplified balance sheet. Assume that banks wish maintain a ratio of 10% cash to total deposits – that is, for the prudential reasons banks will only lend a maximum of 90% of all deposits lodged with them. We have two banks: Bank A and Bank B in the system. Bank A has just received a cash deposit of $100,000. The result is shown in table1 below. Bank A Assets Liabilities Cash $100,000 $100,000 Total $100,000 Total $100,000 Table 1.1 Deposit of $100,000 in Bank A’s Balance Sheet. If there are willing borrowers, granting a loan will change the nature of Bank A’s assets, though not its liabilities. In granting a loan to a customer the banks simply creates a deposit in the customer’s name (or else credits the customer’s account with the agreed amount) but this does not change the amount the bank owes to the existing depositors. 6 MGMT3081 Credit Analysis and Lending However since no person no customer will negotiate a loan that is not required to finance expenditures, it can be assumed that any loan Bank A grants will result in that quantity of funds being withdrawn. After the $90,000 has been withdrawn Bank’s balance sheet will appear as in Table 2. Bank A Assets Liabilities Cash $10,000 Deposits $100,000 Loans $90,000 Total $100,000 $100,000 Table 1.2 Withdrawal of $90,000 Bank A’s Balance Sheet In granting a customer a loan, Bank A exchanges one asset for another asset – that is, it has exchanged cash for a claim against the borrower. However, this is not the end of the process. The person borrowing the $90,000 will spend it and draw a cheque against the bank deposit created in his (her) name. The recipient of the cheque will pay it into his or her bank account. If we assume that this is held at Bank B so that the transaction will result in a transfer of funds from Bank A to Bank B. We can represent the change in Bank B’s balance sheet in Table 3. Bank B Assets Liabilities Cash $90,000 Deposit $90,000 Total $90,000 Total $90,000 Table 1.3 Transfer of funds from Bank A to Bank B. Bank B now has additional cash deposits and just as Bank A was prepared to lend 90% of any additional cash deposits so Bank B will be prepared to lend $81,000 – that is, 90% of $90,000. If this happens Bank B’s cash reserves will fall as cash id withdrawn to finance expenditures. The change is shown in Table 4. MGMT3081 - UNIT 1 7  Bank B Assets Liabilities Cash $9,000 Deposits $90,000 Loans $81,000 Total $90,000 Total $90,000 Table 1.4 Fall in Bank B’s Cash Reserves I invite you to now watch a video on banking to get an overview of banking operations, including the role of credit. Learning Activity 1.2 1. Click on the following link to view a video on banking operations entitled “Banking1”. Banking 1 @ http://www.youtube.com/watch?v=E-HOz8T6tAo 2. Make notes on the key points highlighted in the video on how a bank operates, including the role of credit. So, having watched the video, we now should all have a common understanding of how banks operate and their credit function. Now you may proceed to read the following article which although speaking of banking in Nigeria, highlights general bank operating principles and puts into context the importance of credit and proper credit management to the financial institution and also to the wider economy. Learning Activity 1.3 Read the following article which is available as a pdf file on your course page: Olokoyo, F.O. (2011). Determinants of Commercial Banks’ Lending Behaviour in Nigeria. International Journal of Financial Research, Vol. 2, No. 2, July 2011. 2. Make notes on some factors which are significant to the success of institutional lending. By now we should have a greater appreciation for credit, the role it plays, how it is conducted within the context of a regulated lending institution and the critical success factors. 8 MGMT3081 Credit Analysis and Lending Default Risk: The Downside of Credit Credit or default involves inability or unwillingness of a customer or borrower to meet commitments in relation to lending, trading, settlement and other financial transactions. It is the risk to earnings and capital that the obligor or borrower may fail to meet the terms of any contract with the credit union or other financial institution. Having identified the success factors for lending, we will now look at the downside of credit or the negative risk factors. If we lived in a perfect and predictable world, we could easily say there was no downside to credit as everyone wins, but the reality is that in our world the future is uncertain and there are very few guarantees in life. Events can easily change the course of life and what once seemed to be a promising future can overnight be turned into a gloomy present. This is an inherent risk associated with credit and lending – the changing fortunes of the customer, the economy and the institution. When a lender agrees to receive payment at a future date, there is an inherent risk that the borrower will not settle his debt as agreed; this is default risk, more commonly called, credit risk. So, can a credit institution lend funds without incurring credit risk? The answer is no. Credit risk cannot be avoided but can be managed to mitigate against losses. That is why it is called inherent risk; it is embedded in the transaction itself. Managing the Inherent Risks Associated with Credit Credit risk or default risk involves inability or unwillingness of a customer or borrower to meet commitments in relation to lending, trading, settlement and other financial transactions. It is the risk to earnings and capital that the obligor or borrower may fail to meet the terms of any contract with the banking or other financial institution. This section reviews the principles of managing the risks of bank and other types of financial lending. In the recent years the trends in lending reveal that lending opportunities declined among low risk borrowers; hence the reason for the subprime lending and it attendant problems. Commercial paper, securitization and nonbank competition have pushed banks to find viable loan business among riskier classes of borrowers. Large and stable corporate borrowers that once were the mainstay of banks’ loan portfolios shifted to other sources like commercial paper and the bond market, which tended to have lower transaction costs. Although credit risk cannot be avoided, a properly constructed strategy can minimize losses arising from defaults. The principles of lending have evolved from the practice of lending and although they do not guarantee full compliance, they provide a framework within which one can make a reasonably sound lending decision. There are three basic principles which were identified by the Australian writer, Weerasooriya (1998), as being significant to the lending decision, namely: MGMT3081 - UNIT 1 9  1. Safety of loan 2. Suitability of loan purpose 3. Profitability. We could also add liquidity. A profitable loan is considered to b one that is made at a good interest rate above the bank’s prime lending rate (US) or base rate (UK) and with low administrative cost. But a loan will not be profitable unless it is safe, that is, the customer’s character is good and the bank holds good security. Liquidity suggests that the loan is easily repayable to the bank, that is, the risk of loss is minimal. These principles have been adopted by various writers on credit and so are included in many texts. We will now look at one such writing. Learning Activity 1.4 1. Access the following web site and read the article “Basic Principles of Bank Lending” written by Yushau A. Shuaib. Daily Champion, April 25, 2001. http://www.yashuaib.com/ banklending.htm 2. Make notes on the 3 basic principles of lending. 3. Which of the principles do you think is most critical and why? Discuss with your colleagues and come to a consensus on the most significant principle in risk management. The following article highlights the relevant considerations when lending. Make your notes under the headings used. R. R. Borbora. General Principles of Lending http://cab.org.in/Lists/Knowledge%20Bank/DispForm.aspx?ID=25. Credit Culture According to Hephel, Simonson and Coleman (1999), to overcome their deficiencies in systems and procedures that spawn poor loans, banks must develop a credit culture supported by well conceived management strategies for controlling credit risk. In the broadest sense, credit culture of a bank is the “unique combination of policies, practices, experience and management attitudes that defines the lending environment and determines lending behavior acceptable to the bank”. The credit culture manifests itself in shared beliefs as to the desirability of lending being done on the basis of prudent, commercial and profit oriented criteria and the same reflects in some of the following ways: 10 MGMT3081 Credit Analysis and Lending  A comprehensive approach to asset quality management; Centralised lending policies; Efforts to diversify risk and avoid over-concentration in particular segments, sectors or firms; An explicit approval system for granting loans, with clear delegation of authority and accountability; Separation of loan marketing function from the credit function, and the independence of the latter from the former; and The incorporation of credit quality concerns into the staff performance review process. A poor credit culture has an adverse impact on the asset quality of the bank. It generally results in providing loans for non-commercial reasons, scant regard for the purpose of the loan, and unrealistic payments schedules. For a bank to exhibit an excellent credit culture, the top management should ensure a positive and valuing attitude toward their employees. The management should ensure that they create a healthy credit culture and go beyond the frontiers to fend off the credit risk. Walter Bagehot, a noted economist, banker, political thinker and commentator, critic and man of letters of the 19th century once said: “A bank lives on credit. Till it is trusted it is nothing; and when it ceases to be trusted, it returns to be nothing” A bank whose credit culture is anything other than what has been described above is likely to suffer from lending being done for non-commercial reasons and in the process end-up in poor quality loan assets. The first step is to determine an appropriate credit culture that is consistent with the business values of the management team. For a bank to set a correct culture it must establish it priorities with respect to the marketplace. Priorities may range from emphasizing long- term, consistent performance of the loan portfolio with highly conservative underwriting standards. The first set of priorities is the lower-risk one and suggests goals of superior loan quality with stable earnings; the second set is the higher risk one and suggests acceptable loan quality with superior earnings. Credit Risk Management Strategy Once the credit culture and priorities have been set, the bank must design its credit risk management strategy. Strategy has to do with the process of deciding on objectives of the organisation, on changes in these objectives, on the resources used to attain these objectives and on the policies that are to govern the acquisition, use and disposition of these resources. It is essentially a long-term process. Strategic management of credit risk as a process can be presented in a sequence of several phases: MGMT3081 - UNIT 1 11  Definition of the philosophy and mission of the bank on credit risk; Consolidated analysis of internal and external factors affecting the system of credit risks; Strategic planning for the desired conditions of the given risky positions; Choice of credit risk strategy and the development of credit policies on the related credit risks; Development of mechanisms for implementing credit risk policies and objectives of bank lending policies; and Monitoring and adjustment. Bank credit risk is divided into two basic parts: transaction risk and portfolio risk. A portfolio of loan assets is the group of assets classified by borrower. Although most of the discussion is on transaction risk, we will first define portfolio risk. Portfolio risk is the amount of losses inherent or identified in the portfolio. This risk considers the effects of a loan or security, or other asset on the overall risk of the bank’s asset portfolio. Portfolio risk can further be divided into intrinsic risk and concentration risk. Intrinsic is the risk that is unique to the specific borrower, such as borrower’s customer base, its geographical market, its leverage and so forth. Concentration risk stems from dollar amounts or proportions of bank’s loan portfolio’s that are tied up in certain industries or types of loans (for example, energy, commercial real estate, highly leveraged transactions) as well as certain geographical areas. Transaction risk is addressed in terms of three elements: The bank’s credit organization, with which it administers the credit function The bank’s credit investigation and analysis systems The bank’s standards for underwriting loans – for example, the terms written into loan agreements, the kinds of collateral it accepts, and so forth The need for a loan policy to steer banks toward the desired makeup and control of their loan portfolio is also considered. The Lending Organization The organisational structure of the lending function varies with the size and type of business with a bank’s size and type of business. In a small bank one officer may perform all the detailed work associated with making a loan, including credit investigation and analysis, negotiation and at times collection. In larger banks, individual loan officers specialize in consulting and negotiating with customers and there is greater compartmentalization of support functions such as credit analysis, loan review, and loan collection. 12 MGMT3081 Credit Analysis and Lending Credit Department The primary mission of the credit department is to evaluate the credit worthiness and debt payment capacity of present loan customers and new loan applicants. This evaluation is covered later. Because of the technical nature of its credit evaluation function, the credit evaluation function, the credit department is an excellent place to train loan officers. Trainees may be exposed to a variety of good and not so good loan cases on which they may assist loan officers in making credit decisions. The credit department may also be responsible for loan review, although in larger banks this function is likely to be handled by a separate department. Credit departments are sometimes responsible for collections of past due debts. This function is usually handled by specialists within the department. Collateral and Note Department A crucial and complex loan function is the perfection of the bank’s security interest in collateral offered in support of a loan. The details and documents that are used to take a security interest in collateral offered by prospective borrowers are presented later. The legal complications and paperwork generated in this function often justify its separation from other activities in a unit such as the collateral and note department. This department also performs discount function: the monitoring and crediting of payments received on outstanding notes discounted. Loan Committees Loan committees are responsible for approving banks’ larger loan requests. All banks need effective committees for the review of major loan proposals and loan delinquencies. The committee’s duties are to: 1. Review of major new loans 2. Review of major loan renewals 3. Review of delinquent loans and determine the cause of the delinquency 4. Ensure compliance with stated bank policy 5. Ensure full documentation of loans 6. Ensure consistency in the treatment of loan customers Banks differ in how they structure the loan approval process. Some banks give relative large limits to their loan officers, with the ability to combine their limits with other officers to approve most of the acceptable loan applications. Other banks grant smaller loan limits, and rely mostly on loan committees to approve loans. The first system results in greater flexibility and efficiency; the second system results in greater control and safety. The board of directors also reviews major loans for approval for major projects. This MGMT3081 - UNIT 1 13  committee of the Board makes final judgment on the decision to be given on lending for such projects or large loans, giving closer scrutiny to the largest credits. This committee is especially concerned with conformance to bank loan policy. It also reviews significant past-due loans and credit problems. The Credit Policy The composition and quality of a bank’s loans should be a reflection of its credit policy. The policy reflects the bank’s lending culture, including its priorities, specifying procedures, and means of monitoring lending activities. To ensure that such direction is unambiguous and is communicated to all concerned, the credit policy must be in written form. A credit policy should be handed down by the banks’ board of directors to its management. According to the Comptroller of the Currency (USA) a written loan policy should produce three results: 1. Produce sound and collectible loans; 2. Provide profitable investment of bank funds; and 3. Encourage extensions of credit that meet the legitimate needs of the bank’s market. A credit policy is a set of written guidelines used by lending institutions to set out the parameters for lending. It provides a framework for lending decisions to ensure that loans are made within the limits of regulations and the institutions’ constitutions. Well managed credit institutions have a defined credit policy which is usually included in a credit policy and procedures manual. The policy and procedures manual basically provides guidance and reference for processing credit transactions and making lending decisions. It aims to reduce subjectivity and promotes consistency and transparency in the credit decisions being made. Developing a credit policy and writing a policy and procedures manual is usually a time- consuming activity but there are benefits to be gained for the investment of time and effort. Advantages of having a written credit policy and procedures manual include: It enhances continuity where key personnel leave the credit department. It facilitates consistent credit decisions ensuring that all customers are treated fairly. It can be used as a training tool for new credit officers. It can be used to help evaluate or benchmark job performance against established standards documented in the policies and procedures manual. The credit policy and procedures manual must be relevant to the products and services offered by the institution and the way it operates. To be relevant, the credit policy must be current and it must be kept current. 14 MGMT3081 Credit Analysis and Lending Credit Policy Outline A representative outline for a written loan policy is shown below. Outline for Written Credit Policy I. General Policy Statements A. Objectives B. Strategies 1. Loan Mix 2. Liquidity and maturity Structure 3. Size of the Portfolio C. Trade area D. Credit standards 1. Types of loans 2. Secured vs. unsecured guidelines 3. Collateral 4. Terms E. Loan authorities and approval II. Principles and procedures A. Insurance protection B. Documentation standards and security interest C. Problem loan collection and charge-offs D. Legal constraints and compliance E. Loan Pricing F. Financial information required from borrowers G. Ethical issues and conflict of interest H. Loan review III. Parameters and procedures by type of loan A. Real estate mortgage loans 1. Loan description 2. Purpose of loan proceeds 3. Preferred maturities 4. Pricing: rates and fees 5. Minimum and maximum amounts 6. Insurance requirements 7. Perfection of collateral MGMT3081 - UNIT 1 15  8. Channels of approval for policy B. Interim construction financing C. Accounts receivable D. Inventory loans E. Term loans F. Agricultural loans G. Small business loans H. Consumer loans. The outline is divided into three parts. The first contains general policy statements that specify in broad terms the mission of the bank’s credit department and the desired qualities of the loan portfolio. The second part describes technical principles and procedures to be followed in structuring and administering the loan portfolio. The third part introduces detailed procedures and parameters that apply to various types of loans made by the bank. The following article provides a good overview of credit policy, its relevance and contents. Learning Activity 1.5 Access and read the article, “The Importance of Having a Written Credit and Collection Policy and Procedure Manual” at the following web site http://www.coveringcredit.com/business_credit_articles/Credit_Policies/art585.shtml 2. Make notes on the elements of a credit policy. 3. Michael Dennis, the writer, says, “Having a written credit policy in place and up-to-date is a way of preventing problems and minimizing the loss of customer goodwill.” Give examples from your own experience which show this statement to be correct. 4. Give examples of other means that you know of which can effectively achieve the same result. 16 MGMT3081 Credit Analysis and Lending  Learning Activity 1.6 Critical 1. Obtain a copy of the credit policy and procedures manual at your workplace. 2. Review contents and write a critique of no more than 300 words on the areas addressed. Highlight any area which you think was not properly addressed, making recommendations for improvement of the document, the policy and procedures. Session 1.1 Summary In this session we have looked at some key terms related to credit/ lending, the role of credit, the inherent risks associated with credit/ lending and the basic principles of lending. You were also introduced to risk management strategies to mitigate against losses arising from the inherent risks associated with credit and the use of a credit policy to guide the lending decision and the various clauses it may contain. MGMT3081 - UNIT 1 17 Session 1.2 Cannons of Lending and the Basic Principles of Sound Lending Practice Introduction In order to be a successful lender the banker must be able arrive at the correct equilibrium between the likely income and the threat that the credit may not be repaid. The most significant step is for the banker to establish the requirements for the financial institution to grow its credit portfolio in comparison to the proposals to put to it. The bank’s approach to risk will differ from time to time, usually constant with the present economic environment. To some degree, credit granting is an issue related to commonsense, but in addition to that, if one is to be successful as a lender, there is a need to implement a formal system to assist the process when granting credit so that nothing is missed. That is also essential in a course of study. The Importance of Credit Operations The principal function of a bank/financial institution operating as a commercial concern is to make a profit for its owners/shareholders/ investors. Most of the business of a bank or financial institution of the same or similar nature involves lending to customers and charging them interest. Credit granting may take many forms such as a straight loan, an advance (overdraft) or discounting of an instrument such as a treasury bill or bill of exchange. But the basic aim remains, that is, to make a profit on operations. This is done by: 1. Charging a higher rate of interest to the customer than it pays to depositors and other suppliers of funds it lends; and 2. Ensuring that the cost of administering the loan, that is, collecting the interest and obtaining repayment of the whole advance, does not exceed the profit on the credit. The Lending Proposition The proposal that a lender receives from a borrower should be considered carefully. When a customer asks for a loan the bank would decide whether or not to lend. When the lender receives the proposal, his task is to decide whether: 18 MGMT3081 Credit Analysis and Lending  1. The proposal is acceptable in its current form; 2. It would be acceptable if amended; and 3. It is not acceptable. The proposal should contain specifics such as: 1. The amount requested; 2. The purpose for which the money is to be used, e.g., purchase of an asset, working capital for a business, or consumption spending; 3. The time period for the repayment of the loan; and 4. The source from which the repayment of the loan is to be made and how much can be paid per week, per month or whatever time interval. The lender will then decide based on an assessment of these and other factors whether or not to lend. Guiding Principles The principles of good lending that are normally followed in many lending decision are: 1. The character of the borrower 2. Ability to repay 3. The margin of profit 4. The purpose of the loan 5. The amount of the loan request 6. The repayment terms 7. Security required in case of non-repayment by the borrower (i.e., the secondary source of repayment). The Character of the Borrower The lender must accept that not all will be exactly forthright. He must however be reasonably satisfied that the borrower will be trustworthy in his dealings with the financial institution. The lender must also ensure that the borrower has sufficient financial good sense and willingness so that he can be relied upon to make a good attempt at repaying the loan planned. The character of the borrower can be established and judged with the use of two important techniques: 1. His past record; and 2. A personal interview. MGMT3081 - UNIT 1 19  Ability to Borrow and Repay For personal customers, ability and character are more or less the same since a person of good character should be able to manage his affairs efficiently and satisfactorily. However, for business customers, it is important to assess the ability to manage the affairs of the business of its owners/managers/directors. Some questions that should be answered are: 1. Do they have between them all the requisite skills in areas such as finance and marketing, as well as, in the core business? Good evidence will be obtained by looking at their curriculum vitae and looking for appropriate qualifications as well as their experience. 2. How committed do they seem to be to the venture? 3. If they are expanding into a new area, do they have the experience and knowledge of the market to make the expansion a success? The Margin of Profit The margin is derived from interest, fees, commission and other charges levied on customers. We can recall that banks make loans for profit. In view of this they can consider it very important to levy a rate of interest that aims to achieve this goal. They also charge various types of commissions and other fees to bolster their income. Fixed Rates – Lending policies of financial institutions may stipulate particular rates of interest for certain customers, e.g., prime/base rates for business customers in good standing and say 3% above prime for unsecured overdraft to personal customers. Prime lending rates refer to the best possible lending rates that are available to the most creditworthy customers. A prime company will be able to borrower at 1% or 2% above prime. Base rates are the basic lending rates of a bank on which the lending and deposit rates are based. From the bank’s point of view, base rates represent the marginal cost of borrowing funds, that is, the cost of adding new funds to the financial structure of the bank. Discretionary Rates – In many cases it is up to the lender to decide the rate he will charge customers. Such rate may depend on the volume of deposits these customers have with the institution. For example, the rate charged on a loan might be just a few points on the rate paid on those deposits. It could be also depend on the return the lender requires from the particular lending. The Purpose of the Loan The borrower must state the purpose of the loan he is requesting. This applies to both personal and business loans. A lender should not lend unless he knows what the money is going to be used for. Each lending institution will usually have a policy related to the purpose of the loan; for example, loans for automobiles may be limited certain amounts – between 10% t0 30% to be contributed directly by the borrower and term may be up to 5 years. In addition, prudence may dictate that loans for certain purposes will not be 20 MGMT3081 Credit Analysis and Lending granted at all. Consider the following: 1. Lending for Working Capital Lending funds, usually on overdraft, to finance some of the working capital needs of a business is quite normal, but when the loan is required to finance a large increase in inventory or debtors, the lender should seriously consider the liquidity position of the business. He will also need to assess whether the borrower will need more and more financial assistance as time goes on. 2. Loans for New Business Ventures A request to establish a new business venture should be considered from the point of view that all new business ventures are risky undertakings. Some of them do succeed but most of them fail to make profits and survive. 3. Loan to be Repaid from Non-regular Income Personal loan requests could be for a number of different reasons. In most cases the borrower will be expected to repay the loan from regular income. There are a few exceptions in this however, such as a bridging loan where repayment will come from sale of a house or other loans, or to settle tax liabilities pending receipt from the sale of property or other income. 4. Loans to Repay Existing Debts The financial institution may decide that with good security and a high rate of interest it will lend to the customer to pay off existing debts. However in some circumstances this may be considered too risky. The lender will be effective paying off the customer’s creditors and becoming the sole creditor itself with no equity contribution by the borrower. 5. Loan for Speculative Purposes Speculation is the risk that the value of an asset will rise or fall in the near future and can be bought or sold at a profit. Speculation on the stock exchange, in property, etc., is by its very nature risky business. The lender who lends for this purpose could lose the whole of the loan if the speculation fails. However if it succeeds, the borrower will reap the benefits in excess of the interest and capital repayable to the financial institution. 6. Illegal and Ultra-vires Loans Illegal loans, such as loans for drug smuggling, should not be granted. These pose two dangers to the bank: i) Criminal proceedings as an accessory to a crime; and ii) The likelihood that the loan will not be repaid. Ultra-vires loans are those granted for purposes not sanctioned by the company’s memorandum of association or by-laws. Here the law will give no protection to the lender. Once the borrower has stated the purpose of the loan , the lender should assess whether that is really the purpose of the loan and whether it is in the customer’s best interest and that of the financial institution to have a loan for that purpose. MGMT3081 - UNIT 1 21  The Amount of Loan The credit requests must specify precisely the amount that is required by the borrower. While this may appear obvious, there are four points to consider: 1. The onus is not on the banker to suggest the amount to be lent. 2. The banker should ensure that the borrower is not asking for more than is required for the specific purpose. This is particularly relevant in request to an overdraft facility. This consideration is obviously related to the customer’s ability to pay. 3. The lender must also ensure that the borrower is not asking for less than is required or find out if there is another funding source. If not the lender may be required to lend additional sums to safeguard the original lending. 4. Ideally, the financial stake/contribution of the borrower should usually be sufficient when compared with the amount the lender is being asked to advance. Two issues that require examination are: 1. The amount the customer requires; and 2. The customer’s contribution. In relation to 1) the question that arises is whether the borrower has asked for the requisite amount. The lender should consider this very carefully based on the proposal. For example suppose a banker decided to lend $20,000 to a small business operator but finds that several months later he is asked to lend another $15,000 because the borrower had under estimated his costs or amounts of working capital he needed to invest? What should the lender do? He will be faced with the choice of either lending more money to keep the venture afloat or take action to recover the amounts already lent. What should have happened in the first place would have been for the lender to consider a request for $35,000 and make a decision accordingly. When trying to decide whether a borrower has asked for the correct amount, the banker should assess the following in relation to business applicants: ØØ The budget and cash flow projections prepared by the borrower; ØØ The balance sheet and his likely working capital position, and liquidity after the loan has been granted. If the banker suspects that there will be shortage of liquid funds, he should suggest to the borrower that his borrowing requirements were incorrectly estimated. In relation to the size of the borrower’s contribution/stake, this will depend on a variety of circumstances. In many cases business borrowers are expected to have a stake equal to or greater than that of the lender, as this financial commitment induces greater personal commitment. The banker should not be expected to provide risk capital. However depending on the purpose type of business local institutions may be willing to forego these 22 MGMT3081 Credit Analysis and Lending requirements. With personal lending, different considerations will apply. The borrower will very often be relying on income provided by salaried or wages to repay the loan. Provided there is adequate security, a lender will be prepared to lend a large proportion of the total expenditure, for example, up to 90% of the cost or even more in special cases; and up to 80% or 100% for vehicles in special cases. The borrower’s contribution is usually to the discretion of the management, even allowing for the guidelines. Whatever the agreed size of the lender’s share of the total cost, one golden rule should be that the borrower should contribute enough to ensure that the financial institution’s stake is not put at risk, even allowing for the security provided. Repayment Terms The most important requirement is that it must be repaid. Security is a safety net to be called upon only in the unfortunate and hopefully rare cases that a loan could not be repaid. Security should not be taken and the loan should not be made if the security is likely to be realised. In order to check the likelihood that the borrower will be unable to repay the loan, the banker must complete three tasks: 1. Calculate what payments with interest will have to be. i. In the case of a term loan this means estimating the regular weekly, monthly or quarterly payments with interest. ii. In the case of overdraft, this means checking that the borrower will have enough cash flow in the future to pay interest and gradually reduce the size of the overdraft. 2. Obtain evidence that the source of repayment will be satisfactory. The repayment source must be clear from the outset. i. An employee pay slip ii. Latest profit and loss account, budget and management accounts, and own research an analysis. iii. Deduction of borrowers expenses from his source of income. Security The term security refers to the acquisition of rights taken over property to support a borrower’s personal undertaking to repay. These rights can be exercised if the borrower/ debtor/ does not make payment. An example is a power of sale that may be exercisable by a bank. This is another consideration in a lending decision. It should be stressed that a banker should not grant a loan if he thinks that he would need to realize the security. If a lender decides that security must be given as a consideration of the loan, he must establish: MGMT3081 - UNIT 1 23  Whether there is security available If security is available: a. Can it be easily valued b. Could it be realized fairly easily should the need arise? c. Is it an asset of stable value, a fluctuating value or a value that tends to increase over time? 1. Is it easy for the bank to obtain title over it? A Formal Framework for the Assessment of Lending There are usually five steps involved in a new lending proposition: Introduction This involves the borrower being respectfully introduced by another person, if the institution does not already know him/her. If the borrower was previously a customer of another bank/financial institution, the lender should find out the reasons for the change. The lender should try to see previous bank statements. Accounts opening enquiries should be considered such as references and /or credit references enquiries. The lender should be objective in all cases since the financial institution would not want to take on doubtful customers and incur bad debts. Once the institution starts taking on doubtful customers and the word gets around, a lot of time will be taken up dealing with such situations, and will sacrifice better quality business. However, because of the need to increase business advertising and promotion campaigns by financial institutions this may negate formal introductions. The Application This may be written or verbal but must give details of how the borrowing is to be repaid and how to deal with contingencies. Review of the Application The financial institution should adopt a formal system to ensure that all relevant information is obtained and assessed. Various schemes are utilized by different banks/ financial institutions. In the UK these include CAMPARI, 3C’s plus PARTS and PARSER; in the USA and North America, 5C’s and in the Caribbean, combinations of these. We will focus on CAMPARI and the 5C’s of credit since they appear to be the most comprehensive. CAMPARI stands for Character, Ability, Margin, Purpose, Amount, Repayment and Insurance/Security. Character: Integrity and honest Personal stability Age/health Connections 24 MGMT3081 Credit Analysis and Lending Ability: Can a borrower manage his financial affairs ? Personal resources Personal liabilities Margin: Interest Commission and fees Purpose: Why is the loan needed? Is it in the borrower’s best interest? Is it acceptable to the bank and in line with government policy? Amount: Is the amount correct? What is the borrower’s contribution? What is the amount the institution is willing to lend? Examine borrower’s costings/cash flow statements carefully Allow for contingencies Repayment: Source other than earnings Income Expenditure Can the repayments be met without strain? Repayment amount and period with guidelines Insurance/Security: Is security necessary? Ensure perfected before loan disbursement Life, accident and sickness insurance may be necessary. The 5C’s of credit will be discussed in unit 4. Monitoring and Control The lending should not be forgotten once it has been granted. The account should be reviewed regularly to ensure that the loan is being repaid as agreed, if problems arise the lender should institute supervisory methods; firstly call the customer; then write to and if necessary visit the customer. Types of Customers Lending guidelines can be applied to any type of customer but considerations will vary depending on whether the applicant is a business or private customer or the government. Private Customers The types of loan ordinarily sought by customers are as follows: a. Overdrafts to cover seasonal overspending (large bills, holidays or Christmas expenses). MGMT3081 - UNIT 1 25  b. Personal Loans in order to purchase consumer durables, cars, to finance holiday expenditure, etc). c. Mortgage loans to enable the person to buy or build a house. The loan will be secured by the property itself. Business Customers The individual just starting a business – He/she may be a newly redundant employee with a proposal for a wholly new operation. Sole trader – He/she may be operating for some time and wants to expand through growth or acquisition of another business. The Limited Company – Newly formed or well established, may be seeking funds for working capital or expansion. Public Sector This includes: a. The government, which is usually the largest borrower for some banks, especially indigenous (locally owned) banks. b. Statutory bodies which operate as corporations. These borrow to meet working capital and capital needs. Conclusion The following basic principles should be remembered and used in order to guide the banker in lending situations: 1. Do not risk a decision. If in doubt take time to think. 2. Feel free to ask colleagues for a second opinion. 3. Get full information from the borrower even if it means asking more than once. 4. Always obtain corroboration of borrower’s statements where possible. 5. Take care to distinguish between facts, estimates and opinions when making decisions. 6. First impressions and “gut reaction” are often correct. If they are unfavourable and linger, then take care. 26 MGMT3081 Credit Analysis and Lending  Learning Activity 1.7 Self-Assessment Questions 1. Name the five stages to any analysis of a new lending proposition. 2. Set out the seven stages in reviewing an application for a loan. 3. What is meant by “margin” in the seven stage review? 4. If your bank uses a different mnemonic from CAMAPARI to assist in reviewing lending applications, describe it briefly. 5. Set out the account opening procedures used by your bank/financial institution to establish, as far as possible, that a new customer is honest and trustworthy. 6. In your opinion, what would you regard as the most important of the seven stages of revew? Why? 7. Set the six basic principles to be applied to lending proposals. 8. In what ways might a lender judge the character of a borrower? 9. What are the two most suitable methods for assessing whether a business customer has requested a loan that is sufficient for his needs? 10. Why should a borrower be expected to contribute some money himself towards the capital expenditure or investment that is proposed? MGMT3081 - UNIT 1 27  Learning Activity 1.8 Problem Question Jeremy Johnson has maintained an account at your bank for several years. You have very little detailed information on file concerning him but you are aware that he has business interest in Castries, he is a director of three companies and from time to time sits on boards of enquiry set up by government. No regular credits are seen in his account but over the past year, credits amounting to $25,000 have been received including six dividend warrants totaling near $7,500. Some nine months ago, your institution wrote to Mr. Johnson suggesting that the dividends be mandated direct to his account, but there has been no response to the letter. Over two years ago Mr Johnson wrote to you regarding a credit card issued by your bank. Later a formal application was received from him; you approved the application and a new card was issued. As part of this facility an unsecured overdraft limit of $7,500 was recorded in Mr Johnson’s account. Today you received a letter from Mr Johnson enclosing a cheque for $20,000 drawn in his favour by a firm of lawyers and three share certificates, all drawn in his name with a market value of $80,000. He explains that he is involved with a group of investors; they are about to complete the purchase of a business in another island but at this moment he can give no details. He is therefore likely to issue a cheque over the next week for $100,000 and asks you to arrange to increase his overdraft by $75,000. Statistics of Mr Johnson’s account over the past three years are as follows: Year High Low Average Dr ($) ($) ($) Turnover 1998 7,300cr 1,600dr 2,400cr 21,400 1999 6,300cr 4,800dr 1,800cr 24,100 2000 6,300cr 4,900dr 1,600cr 22,800 2001(8mth) 4,700cr 5,300dr 900cr 13,700   28 MGMT3081 Credit Analysis and Lending Your task: Applying the principles you learned in this unit, set out in detail your reply to Mr. Johnson. Share and review the main points of your response with your group. Discuss your reasons for your response with your classmates in the discussion forum. UNIT SUMMARY In this session we looked at the basic concepts of lending and how to use a formalized approach to analysing a lending proposition. Lending is undertaken by a financial institution in order to make profit but to safeguard that profit, it is also necessary for the loan to be safe and for the borrower to be liquid. These are the basic principles of good lending. The lender must view the lending proposition in the light of the institution’s lending policy and the decision to lend would depend on the application of the principles of lending or lending guidelines. MGMT3081 - UNIT 1 29  References Banking 1 http://www.youtube.com/watch?v=E-HOz8T6tAo Borbora, R. R. (2008). General Principles of Lending http://cab.org.in/Lists/Knowledge%20Bank/DispForm.aspx?ID=25 Dennis, M. C. (2004). Credit Policy and Procedure Manual http://www.coveringcredit.com/business_credit_articles/Credit_Policies/art585. shtml Hephel,G. H., Simonson, D. G., and Coleman, A. B. (1999). Bank Management: Text and Cases. NJ: John, Wiley and Sons. Shuaib, Y. A. (2001). Basic Principles of Bank Lending. http://www.yashuaib.com/banklending.htm 30 MGMT3081 Credit Analysis and Lending