Chapter 16 Lending Policies Procedures Managing Credit Risk Types of Loans Real Estate Loans Secured by real property land buildings and include short term construction loans and long term loans to finance the purchase of homes apartments land etc Financial Institution Loans Credit to banks insurance companies finance companies and other institutions Agricultural Loans Extended to farms and ranches to assist in planting and harvesting crops and supporting the feeding and care of livestock Commercial Industrial Loans Granted to businesses to cover the purchasing of inventory paying taxes and payroll Loans to Individuals Credit used to finance automobile purchases mobile homes retail goods medical care and other personal expenses can be extended directly or indirectly through retail dealers Miscellaneous Loans not listed above securities loans Lease Financing Receivables Lender buys equipment or vehicles and leases them to its customers Largest dollar volume is Real Estate loans accounting for just over of total bank loans Next largest are loans to individuals followed closely by commercial and industrial loans each representing 1 5 of bank loans Factors Determining Lender s Loan Portfolio Growth Mix Key Factor Profile of the characteristics of the market area it serves Key Factor Lender size Wholesale Lenders Large banks composed of large denomination loans to businesses Retail Credit Smaller banks dealing in smaller personal cash loans and mortgages extended to individuals families and small businesses Smaller banks are more heavily committed to real estate and agricultural loans Large banks are more tied to commercial and loans to individuals Key Factor Experience and expertise of management and loan policy Key Factor Expected yield Gross yields have been highest among credit card loans installment loans and real estate loans Key Factor Lender Customer Size Small banks tend to have higher net returns on real estate and commercial loans Lending institutions should make those types of loans for which it is the most efficient producer Regulation of Lending Mix quality and yield of the loan portfolio are influenced by the character and depth of regulation in the industry Banks are frequently prohibited from making loans collateralized by their own stock Volume of real estate loans granted cannot exceed that bank s capital and surplus or 70 of its time and savings deposits Unsecured loans to a single customer cannot exceed 15 of a single national bank s unimpaired capital and surplus account known as legal lending limit Participating with one or more lenders in the same loan can increase the amount of credit banks can grant Banks can create holding companies to enhance their ability to handle large loans Community Reinvestment Act 1977 Requires lenders to make an affirmative effort to meet the credit needs of those in their territories so no local areas are discriminated against Equal Credit Opportunity Act 1974 An individual cannot be denied credit because of race sex religion or age Disclosure laws require borrower be quoted true cost as reflected in the APR The International Lending Supervision Act requires U S banks to make public any credit exposures to a single country that exceed 15 of their primary capital or 75 of their total assets Uniform Financial Institutions Rating System Each banking firm is assigned a numerical value based on quality of asset portfolio 1 Strong Performance 2 Satisfactory Performance 3 Fair Performance 4 Marginal Performance 5 Unsatisfactory Performance Criticized Loans Perform well but have minor weaknesses because the lender has not followed its loan policy or failed to get full documentation Scheduled Loans Appear to contain significant weaknesses or represent a dangerous concentration of credit in one borrower or industry Loans carrying an immediate risk of not paying are adversely classified where they are grouped 1 Substandard Loans Loan s margin of protection is inadequate due to weak collateral or weakness in borrower s repayment ability 2 Doubtful Loans Carry a strong probability of an uncollectible loss 3 Loss Loans Uncollectible and not suitable as bankable assets CAMELS Rating Capital Adequacy Asset Quality Earnings Record Liquidity Position Management Quality Sensitivity to Market Risk Written Loan Policy Gives loan officers specific guidelines in making individual loan decisions and shaping the overall loan portfolio One of the most important ways lending institutions make sure its loans meet regulatory standards are profitable is to establish a written loan policy Steps in the Lending Process 1 Finding Prospective Loan Customers Loans to individuals can come from a direct request from customers Business loans arise from solicited accounts in lender s area 2 Evaluating Perspective Customer s Character Sincerity of Purpose Interview with a loan officer to explain customer s credit needs 3 Making Site Visits Evaluating Customer s Credit Record With mortgage loans a loan officer often makes a site visit to assess location and condition of the property Contact previous creditors to see if customer adhered to previous loan agreements 4 Evaluating Customer s Financial Condition Customer submits documents including financial statements Determination of cash flow sufficiency is made 5 Assessing Loan Collateral Singing the Loan Agreement Ensure lending institution has access to collateral or can acquire title to property involved referred to as perfecting 6 Monitoring Compliance with Loan Agreement and Customer Service Needs Monitored to ensure loan s terms are being followed What makes a good loan 1 Is the borrower creditworthy 2 Can the loan agreement be properly structured and documented 3 Can the lender perfect its claim against collateral The C s of Credit Character Loan officer must be convinced the customer has well defined purpose and intention to repay Responsibility truthfulness serious purpose and serious intention make up character Capacity Must be sure customer has the authority to request a loan and legal standing to sign a binding agreement Cash Does the borrower have the ability to generate enough cash flow 3 sources drawn upon to repay loans 1 Cash from sales income 2 Sale Liquidation of assets 3 Issuing debt securities Cash Flow Sales Rev COGS Selling Admin Expenses Taxes paid in cash Noncash Expenses Traditional Cash Flow Cash Flow Net Profits Noncash Expenses Direct Cash Flow 1 Net cash flow from operation 2 Net cash flow