RECENT TRENDS IN LOAN GROWTH AND  Ability to repay debts varies with changes in  Credit review / loan review

QUALITY employment and net worth. - Banks perform - The review process can be divided into 2
 Commercial banks extend credit to credit analysis on each loan request. functions:
different types of borrowers for many  Changes in general economic conditions and 1. Monitoring the performance of existing
different purposes. firm’s operating environment are difficult to loans
 For most customers, bank credit is the predict. 2. Handling problem loans – special
primary source of available debt  There are several other sources of credit risk treatment
financing, whereby for depository that may not well be represented in the bank’s  Each function reflects the bank’s written loan policy as
institutions, good loans are the most aggregate historical credit risk data. determine by the BODs.
profitable assets.  Concentration Risk - Exists when banks lend  The bank will underlie on 3 concepts;
 The most prominent assumed risk is credit in a narrow geographic area or concentrate  Loan policy – formalizes lending guidelines that
risk. Many factors can lead to loan their loans in a certain industry. employees follow to conduct bank business.
defaults.  Country Risk - refers to the potential loss of  Credit philosophy – determines how much risk the
 Firm – changing technology, labor strikes interest and principal on international loans bank will take and in what form.
 Individual – personal income rises and due to borrowers in a country refusing to  Credit culture – refer to the fundamental principles
falls. make timely payments. that drive lending activity ang how mgt analyzes
 Interest rate risk also arises from credit risk.
decisions. Such as loan maturity, pricing.
 Loan are the dominant asset in most CREDIT PROCESS
banks portfolio, comprising on average  The credit process includes 3 functions; CHAPTER 16
50% – 75% of total assets.  Business development and credit analysis
ESSENTIALS OF CREDIT RISK
 - Business development is a responsibility of
ANALYSIS
every bank employee to market the bank
MEASURING AGGREGATE ASSET QUALITY
services to existing and potential
 Asset quality – evaluation of asset that will
customers.
measure the credit risk that associated with it.
- Credit analysis is essential default risk
 Extremely difficult to assess individual asset
analysis in an attempt to evaluate CHARACTERISTICS OF DIFFERENT TYPES OF
quality using aggregate quality data.
borrower’s ability and willingness to LOANS
 Different types of assets and off balance sheet
repay.  The Uniform Bank Performance Report
activities have different default probabilities. -
- Evaluate 5’C of good credit and bad credit. (UBFR) classifies loans into 6 types:
Loans typically exhibit the greatest credit risk.
 Credit execution and administration  Real estate loans
 Bank will evaluate the portfolio credit risk - The process by which the formal credit  Commercial loans
through; decision is made varies by bank.  Individual loans / consumer loans
- Evaluation of historical loss rate on loan - The formal decision can be made  Agriculture loans
and investment individually, by an independent  Other loans and leases in domestic
- Expected losses in the event of a default underwriting department, by loan offices
- Plan to overcome the expected losses committee or through combination of  Lean and leases in foreign offices
various methods.
5Cs OF GOOD CREDIT 5Cs OF BAD CREDIT
 Character  Complacency
 Refer to the borrower’s honesty and trustworthiness.  Refer to the tendency to assume that because things were good
 An analyst must assess the borrower’s integrity and subsequent in the past, they will be good in the future.
intent to repay.  Common examples are an over-reliance on guarantors, reported
 If there are any doubts, the loan should be rejected. net worth, or past loan repayment success because things have
 Capital always worked out in the past.
 Refer to the borrower’s wealth position measured by financial  Carelessness
soundness and market standing.  Involves poor underwriting typically evidenced by inadequate
 Capital helps cushion losses and reduces likelihood of loan documentation, a lack of current financial information or
bankruptcy. pertinent information in the credit files, a lack of protective
 Capacity covenants in the loan agreement.
 Involves both borrower’s legal standing and mgt’s expertise in  Each of these makes it difficult to monitor’s borrower’s progress
maintaining operations so the firm or individual can repay its and identify problems before they become unmanageable.
debt obligations.  Communication ineffectiveness
 A business must have identifiable cash flow or alternative  Refers to when a bank’s credit objectives and policies are not
sources of cash to repay debt. well communicated.
 An individual must be able to generate income.  This is when loan problem can arise.
 Conditions  Mgt must effectively communicate and enforce loan policies,
 Refer to the economic environment or industry specific supply, and loan officers should make mgt aware of specific problems
production, and distribution factors influencing a firm’s with existing loans as soon as they appear.
operations.  Contingencies
 Repayment sources of cash often vary with the business cycle or  Refer to lender’s tendency to play down or ignore circumstances
consumer demand. in which loan might be default.
 Collateral  The focus is on trying to make deal work rather than identifying
 Refer to the lender’s secondary source of repayment or security downside risk.
in the case of default.  Competition
 Having an asset that the bank can seize and liquidate when a  Involves following competitor’s behavior rather than maintaining
borrower defaults reduces loss, but does not justify lending the bank’s own credit standards.
proceeds when the credit decision is originally made.  Doing something because the bank down the street is doing it
does not mean it’s prudent business practice.