Chapter Sixteen

Lending Policies and Procedures:

Managing Credit Risk
Key Topics

• Types of Loans Banks and Competing Lenders 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
Introduction

• However, risky or not, the principal reason many financial firms are issued charters of
incorporation by state and national governments is to make loans
• Lenders are expected to supply credit for all legitimate business and consumer financial
needs and to price that credit reasonably
• Loans support the growth of new businesses and jobs within the lender's market area
• Loans frequently convey information to the marketplace about a borrower's credit quality
• The lending process bears careful monitoring at all times
Types of Loans

• Real Estate Loans

• Financial Institution Loans
• Agriculture Loans
• Commercial and Industrial Loans
• Loans to Individuals
• Miscellaneous Loans
• Lease Financing Receivables

• The largest category in dollar volume is real estate loans, followed by loans
to individuals, and commercial, and industrial (C&I) loans
 16-5TABLE 16-1 Loans Outstanding for All FDIC-Insured Banks as of December 31, 2010 (consolidated
domestic and foreign offices)

Percentage of Total Loan Portfolio

Bank Loans Amount for All Percentage of Smallest U.S. Largest U.S.
Classified by Purpose FDIC-Insured Total Loans for Banks (less than $100 Banks(over
Of Loan U.S.Banks All FDIC-Insured U.S.Banks million S1 billion
($ billions) in total assets) in total assets)

Real estate loansa $3,650.4 55.% 66.0% 55.7%

Loans to depository
Institutionsb 102.4 1.6 0.1 1.7
Loans to finance
agricultural production 59.1 0.9 11.0 0.4
Commercial and
industrial loansc 1,123.1 17.0 14.0 17.4
Loans to individualsd 1,128.1 19.5 7.4 20.4

Miscellaneous loanse 334.8 5.1 1.0 5.6

Lease financing receivables 99.6 1.5 0.4 1.7
Total(gross)loans and l eases shown
on U.S.
banks' balance sheet
$6,597.5 100.0% 100.0% 100.0%
 Types of Loans (continued)
• Factors Determining the Growth and Mix of Loans
 Characteristics of the market are
 Lender size
o Wholesale lenders vs. retail credit
 Experience and expertise of management
 Loan policy
 Expected yield of each type of loan
 Regulation

 General rule: A lending institution should make the types of loans for
which it is the most efficient producer
Regulation of Lending
•The mix, quality, and yield of the loan portfolio are heavily influenced by regulation
•Examples of lending regulations:
oThe total volume of real estate loans granted by a U.S. national bank cannot exceed that
bank's capital and surplus or 70 percent of its total time and savings deposits, whichever is
greater
oAn unsecured loan to a single customer normally cannot exceed 15 percent of a single
national bank's unimpaired capital and surplus account (legal lending limit)
•Any loans made are subject to examination and review
Regulation of Lending (continued)
•The Community Reinvestment Act of 1977
oSelected lenders to must make “an affirmative effort” to meet the credit needs of individuals
and businesses in their trade territories so that no areas of the local community are
discriminated against in seeking access to credit
•The Equal Credit Opportunity Act of 1974
oNo individual can be denied credit because of race, sex, religious affiliation, age, or receipt
of public assistance
•The International Lending and Supervision Act
oRequires U.S. banks to make public any credit exposures to a single country that exceed 15
percent of their primary capital or 0.75 percent of their total assets, whichever is smaller
oThis law also imposes restrictions on the fees lenders may charge a troubled international
borrower to restructure a loan
Regulation of Lending (continued)
•Uniform Financial Institutions Rating System
oEach banking firm is assigned a numerical rating based on the quality of its asset
portfolio
oThe federal examiner may assign one of these ratings:
o 1=strong performance
o 2=satisfactory performance
o 3=fair performance
o 4 = marginal performance
o 5 =unsatisfactory performance
Regulation of Lending (continued)
•Asset Quality
oCriticized loans
oScheduled loans
oAdversely classified loans
oSubstandard loans
oDoubtful loans
oLoss loans
 Regulation of Lending (continued)
•CAMELS Rating
oCapital adequacy
oAsset quality
oManagement quality
oEarnings record
oLiquidity position
oSensitivity to market risk exposure
•All six dimensions of performance are combined into one overall numerical rating, referred to as the
CAMELS rating
oDepository institutions whose overall rating is low tend to be examined more frequently than the highest-
rated institutions
Regulation of Lending (continued)
•Establishing a Good Written Loan Policy
oImportant in order to meet regulatory standards
oWhat should a written loan policy contain?
oA goal statement for the entire loan portfolio
oSpecification of lending authority of each loan officer and loan committee
oLines of responsibility in making assignments and reporting information
oOperating procedures for soliciting, evaluating and making loan decisions
oRequired documentation for all loans
 Regulation of Lending (continued)

•Establishing a Good Written Loan Policy

oLines of authority for maintaining and reviewing credit files
oGuidelines for taking, evaluating, and perfecting loan collateral.
oProcedures for setting loan rates and fees and the terms for repayment of loans
oA statement of quality standards applicable to all loans
oA statement of the preferred upper limit for total loans outstanding
oA description of the lending institution's principal trade area
oProcedures for detecting and working out problem loan situations.
 Steps in the Lending Process
1. Finding Prospective Loan Customers
2. Evaluating a Customer's Character and Sincerity of Purpose
3. Making Site Visits and Evaluating a 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
 Credit Analysis: What Makes a Good Loan?
1. Is the Borrower Creditworthy? The 6Cs of Credit
•Character
oSpecific purpose of loan and serious intent to repay the loan
•Capacity
oLegal authority to sign binding contract
•Cash
oAbility to generate enough cash to repay loan
•Collateral
oAdequate assets to support the loan
•Conditions
oEconomic conditions faced by borrower
•Control
oDoes loan meet written loan policy and how would loan be affected by changing laws and regulations
 Credit Analysis: What Makes a Good Loan?
(continued)
2. Can the Loan Agreement Be Properly Structured and Documented?
• This requires drafting a loan agreement that meets the borrower's need for funds
with a comfortable repayment schedule
o If a major borrower gets into trouble because of an inability to service a loan,
the lending institution may find itself in trouble
• Proper accommodation of a customer may involve lending more or less money
than requested over a longer or shorter period
Credit Analysis: What Makes a Good Loan?
(continued)
3. Can the Lender Perfect Its Claim against the Borrower's Earnings and Any
Assets That May Be Pledged as Collateral?
• Reasons for Taking Collateral
oIf the borrower cannot pay, the pledge of collateral gives the lender the right to seize and sell those
assets
oIt gives the lender a psychological advantage over the borrower
•Types of Collateral
oAccounts Receivables
oFactoring
oInventory
oReal Property
oPersonal Property
oPersonal Guarantees
EXHIBIT 16-1 Safety Zones Surrounding Funds Loaned in Order to Protect
a Lender
Personal guarantees and pledges made by the

Strength of the customer’s balance sheet

Customer’s expected profits, income.

The amount owed the lender that is exposed to risk equals

the principal amount of the loan plus interest owed minus
any deposits maintained by the customer

or cash flow

Liquidity and collateral pledged

Owners of a business firm or by cosigners to a loans

TABLE 16-4 Sources of Information Frequently Used in Loan Analysis and Evaluation by Lenders and Loan Committees
Information about Consumers (Individuals and Families)Borrowing Money
Customer-supplied financial statements
Credit bureau reports on a borrower's credit history
Experience of other lenders with the borrower
Verification of employment with a borrower's employer
Verification of property ownership through local government records
The World Wide Web

Information about Businesses Borrowing Money

Financial reports supplied by the borrowing firm
Copies of boards of directors' resolutions or partnership agreements authorizing borrowing
Credit ratings supplied by Dun & Bradstreet Moody's Investor Service, Standard & Poor's Corporation, Fitch, etc.
The New York Times and The New York Times Index
The Wall Street Journal, Fortune, and other business publications
Risk Management Associates (RMA) or Dun & Bradstreet industry averages
The World Wide Web

Information about Governments Borrowing Money

Governmental budget reports
Credit ratings assigned to government borrowers by Moody's, Standard & Poor's Corporation, etc.
The World Wide Web

Information about General Economic Conditions Affecting Borrowers

Local newspapers and the Chamber of Commerce
The Wall Street Journal, The Economist, and other general business publications
U.S. Department of Commerce
Central bank business data series (as in the Federal Reserve Bulletin)
The World Wide Web
Parts of a Typical Loan Agreement

•The Promissory Note

•Loan Commitment Agreement
•Collateral
•Covenants/Contact
oAffirmative
oNegative
•Borrower Guaranties or Warranties
•Events of Default
Loan Review
1. Carrying out reviews of all types of loans on a periodic basis
2. Structuring the loan review process
o Record of borrower payments
o Quality and condition of collateral
o Completeness of loan documentation
o Evaluation of borrower's financial condition
o Assessment as to whether the loan fits with the lender's loan policies
3. Reviewing Largest Loans Most Frequently
4. Conducting More Frequent Reviews of Troubled Loans
5. Accelerating the Loan Review Schedule if Economy or Industry Experiences
Problems
 Loan Workouts
•Loan workout - the process of recovering funds from a problem loan situation
•Warning Signs of Problem Loans
1. Unusual or unexpected delays in receiving financial statements
2. Any sudden changes in accounting methods
3. Restructuring debt or eliminating dividend payments or changes in credit rating
4. Adverse changes in the price of stock
5. Losses in one or more years
6. Adverse changes in capital structure
7. Deviations in actual sales from projections
8. Unexpected or unexplained changes in deposits
 TABLE 16-5 Warning Signs of Weak Loans and Poor Lending Policies
The manual given to bank and thrift examiners by the FDIC discusses several telltale indicators of problem loans and poor lending
policies:
Indicators of a Indicators of Inadequate of
Weak or Troubled Loan Poor Lending Policies

Irregular or delinquent loan payments Poor selection of risks among borrowing

Frequent alterations in lean terms customers
Poor loan renewal record (little Lending money contingent on possible
redaction of principal when the lean is renewed) future events(such as a merger)
Unusually high loan rate (perhaps an attempt Lending money because a customer
to compensate the lender for a high- risk loan) premises a large deposit
Unusual or unexpected buildup of the Failure to specify a plan for loan liquidation
borrowing customer's accounts receivable High proportion of leans outside the lender's trade territory
and/or inventories Incomplete credit files
Rising debt-to-net-worth (leverage)ratio Substantial self-dealing credits (loans to
Missing documentation (especially missing financial statements) Insiders-employees, directors, or
Poor-quality collateral stockholder)
Reliance on reappraisals of assets to increase the borrowing customer's net Tendency to overreact to competition
worth (making poor loans to keep customers from
Absence of cash flow statements of going to competing landing institutions)
projections Lending money to support speculative
Customer reliance on nonrecurring sources purchases
of funds to meet loan payments ( e.g., selling Lack of sensitivity to changing economies
buildings or equipment) conditions
 Loan Workouts (continued)
•What steps should a lender take when a loan is in trouble?
1. Do not forget the goal: Maximize full recovery of funds
2. Rapid detection and reporting of problems is essential
3. Loan workout should be separate from lending function
4. Should consult with customer quickly regarding possible options
5. Estimate resources available to collect on loan
6. Conduct tax and litigation search
7. Evaluate quality and competence of management
8. Consider all reasonable alternatives

• Preferred option: Seek a revised loan agreement

Quick Quiz
•Why is lending so closely regulated by state and federal
authorities?
•What is the CAMELS rating, and how is it used?
•What three major questions or issues must a lender consider in
evaluating nearly all loan requests?
•Explain the following terms: character, capacity, cash, collateral,
conditions, and control.
•What sources of information are available today that loan
officers and credit analysts can use in evaluating a customer loan
application?
•What is loan review?