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Week 3 Corporate and Small

Business Lending
 The Bank Loan Portfolio

• Banks want a robust loan portfolio.

• This means that the losses due to shocks and
adverse circumstances are as low possible.
• One way to increase loan portfolio robustness is
to be well diversified.
• However, some types of shocks, such as the
general level of interest rates cannot be
diversified away.
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 Ensuring robustness

• In order to ensure robustness we will impose

conditions on the customer.
• Some customers will not like these conditions
or argue that they are too onerous.
• In this case the customers can choose to
borrow elsewhere if they wish, other banks
may have lending policies in place which
allow these risks.

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 Lending Policy

• In order to ensure that the loan portfolio has an

acceptable level of risk there will be a lending
policy in place.
• The lending policy will specify the types of
loans the bank is willing to write, and the
circumstances under which those will be
written.

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 Extending our time value of money
calculations: Borrowing Capacity
• Let us assume that Mr Smith has an annual income of $100,000
per annum and wishes to borrow to buy a home.
• He considers two possible banks, each bank with a different
lending policy.
• For loan proposals like these a bank will have a policy called a
borrowing capacity. This is the amount of your gross income that
you can devote to your loan payments.
• Let us assume that the relevant interest rate starts at 6.5% per
annum, calculated monthly over a 30 year period.
• Bank A has a policy of thirty percent borrowing capacity while
Bank B has a thirty five percent borrowing capacity policy.

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 Part A: the first calculations
• How much can Mr Smith can borrow from Bank A?
– 30% of $100,000 = $30,000 per annum or $2,500 per month,
– This means at 6.5% per annum over 30 years with monthly
payments the maximum is PMT = 2,500; i = 6.5/12=0.5416666,
n = 30 * 12= 360, FV = 0, CPT PV = $395,527
– Mr Smith can borrow $395,527 from Bank A.
• How much can Mr Smith borrow from Bank B?
– 35% of $100,000 = $35,000 per annum or $2,916.66 per
month.
– This means at 6.5% per annum over 30 years with monthly
payments the maximum is PMT = $2,916.66; i =
6.5/12=0.5416666, n = 30 * 12= 360, FV = 0, CPT PV =
$461,447,17
– Mr Smith can borrow $461,447.17 from Bank B
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 Impact on After tax income
• Using a simple online tax calculator Mr Smith
will have to pay $24,947 in tax over the year,
so his monthly after tax income is ($100,000 -
$24,947) /12 = $6,254.42 per month.
• Borrowing from Bank A means Mr Smith will
spend 39.99% of his after tax (net) income on
his mortgage. If he borrows from Bank B Mr
Smith will spend 46.63% of his after tax (net)
income.

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 Part B: the next step.
• Two years have passed and interest rates start to increase. The loan mortgage
rate goes from 6.5% to 8%. Let’s see what happens.
• As two years have passed Mr Smith has paid off part of his mortgage:
– Bank A: Mr Smith owes Bank A the present value of 28 years of monthly payments
of $2,500 at 6.5% per annum: PMT = 2,500, n = 28*12= 336, FV = 0, i = 6.5/12 =
0.541666, COMP PV = 386,389.16.
– Compute new payments at 8%: PV = 386,389.16, n = 336, i = 8/12 = 0.66666, FV= 0,
COMP PMT = $2,885.39.
– Bank B: Mr Smith owes Bank B the present value of 28 years of monthly payments
of $2,916.66 at 6.5% per annum: PMT 2,9166.66, n = 336, i = 0.541666, COMP PV =
450,786.32.
– Compute new payments at 8%: PV = 450,786.66, n = 336, i = 0.66666, FV = 0, COMP
PMT = $3,366,29.
• Of course, Mr Smith’s salary has increased over the last two years, it is now
$106,000 per annum. His monthly after tax income is $6,569.42.
• He is now paying 43.94% of his net income to Bank A or 51.24% of his net
income to Bank B.

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 Part C: things get worse
• Rising interest rates mean that the economy is now slowing. Mr
Smith’s industry (the building industry) is hit particularly hard.
• Mr Smith’s employer announces that all employees will be on a 8 day
fortnight and 80% salary. Mr Smith finds that many others in his
industry have lost their jobs and no-one is hiring, so the 80% salary is
the best deal around.
• His new salary is 0.8 * 106,000 = 84,800. This means a monthly net
salary of $5,456.42.
• If he had borrowed from Bank A he is now paying 52.88% of net
salary. If he had borrowed from Bank B he is now paying 61.69% of
net salary.

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 Part D: just when you think things
cannot get worse, they do.
• The prudential regulator is concerned by the impact of the economic
slowdown on the asset quality of some bank’s loan portfolios, and
conducts a detailed analysis of each bank.
• The outcome is favourable to Bank A, but the regulator is worried about
Bank B and instructs it to raise more capital to support its loan portfolio
in case of future losses.
• The outcome for Bank B is that it must increase its loan interest rate by
0.35% to 8.35%.
• Assuming the same loan details as in Part B, but the same income as
Part C, Mr Smith’s new payments to Bank B are now: PV = 450,786.88,
n = 336, i =8.35/12 = 0.695833, FV = 0, CPT PMT = 3,474.85.
• This means that Mr Smith would be paying 63.68% of his net income to
Bank B.
– Can he afford to keep making those payments?

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 Lesson: Borrowing capacity
• Just because one bank is willing to lend you
more money does not mean it is a good idea to
borrow that much.
• You need to consider issues such as:
– What happens if interest rate rise?
– How likely is it that interest rates will rise?
– Will I keep my job?
• More conservative borrowing capacity limits
often exist for reason.
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 Predatory Lending

• Predatory lending is an unethical practice

whereby the lender imposes unfair deceptive or
fraudulent loan terms upon a borrower.
• This occurs because the borrower is frequently
relying upon the financial advice provided by
the lender.
• Another example of predatory lending is to
extend loans when it is clear the borrower is
likely to experience difficulty repaying the loan.
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 Monitoring

 Monitoring is the tedious but important part of

lending management.
 In Week 3 we have several cases where our
analysis indicated that the loan would need careful
monitoring in order to be viable.
 In order to achieve an adequate information flow,
banks will often require that the customer has all
of its financial relationships with the bank.

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Sources of Monitoring

 The text book list:

– Internal records.
– Visits and interviews.
– Audited financial accounts.
– Management accounts.

 Also industry trend reports.

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Internal reports

 The daily refence report (exceptions report).

– The report of accounts that are overdrawn.
 The Summary account report and trends.
– This provides an overview of how an account has been managed.
 What are the highest and lowest debits balances (identifies if the
overdraft has a core element).
 Is there a trend in balance that is of concern?
 Are there indicators that revenues are now being banked elsewhere?
(eg sales figures do not match with deposits).
 Are there any seasonal trends we need to monitor?

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 Visits and Interviews

 In many of our loan cases we are taking security over

buildings or machines.
– Keeping an eye on this security is important.
 A visit helps you understand a business in a way financial
statements cannot.
 It shows you are interested in your customer.
 Customers may talk more freely on their home ground.
 You can meet members of the management team you
may not have met previously.
 They allow you to form a fuller picture of the business.

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Audited Accounts

 These provide a (hopefully) objective picture of the

financial situation of the business.
 The receipt of audited account provided a good time to
review the loan account and compare budget projections
with outcomes.
– We are relying on the quality of the auditor.

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 Management Accounts.

 These are the accounts produced by the firms

managements, but not audited.
– They may not be as professionally prepared, but can give more
immediate insights into how the business is faring.
 They help us see how budget forecasts are holding up to
reality.
– Deviations between budgets and management accounts provide
and opportunity for a dialogue between the bank and the
customer, and hopefully prevent negative events resulting in
financial distress.
– While a single month falling short of budget projections should not
result in the ‘panic button‘ being hit, overall trends should be
monitored and seasonal factors understood.

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 Creative Accounting

 One concern with accounting information

presented to a bank is that it may have been
prepared to prove a point.
 An extreme example of this type of accounting
scandal is the Enron case.
 However, in general this type of problem is less
frequent and creative accounting is likely to be
more subtle.

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Types of creative accounting

 Inflating Profits.
 Taking cash out of the till to reduce taxes.
 Bringing revenue forward.
 Reducing costs /pushing costs back.
 Increasing debtors maturity: allowing clients longer to
pay.
 Adjusting profits and losses via the balance sheet, for
example by changing the value of the fixed assets.
 Capitalising expenses to increase profits.

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How to deal with these concerns?

 This is not a course in accounting but rather I aim to

provide you with a series of warning signs that suggest
the accountants should be called in.

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Inflating Sales

 Look for increases in sales without increased cash flow

through the operating account or increased Debtors.
– If a firm is attracting sales in increasing settlement periods then
there will be no immediate increase in cash but instead an
increase in debtors.
– If the increased sales are inflated then there will be no cash
eventuating.
 Some firms will inflate sales via intra group transfers.
 When questioned some firms will say the cash went through an
operating account with a different bank, so ask for the statements of
the account.
– Some firms will ‘adjust’ the timing of sales, eg bringing forward
into the current financial year.
 One case involved a Health Club simply charging membership fees
in December for the January membership.

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Hiding profits

 Using the balance sheet to hide profits:

– The most common here is asset revaluations.
 Reporting profits that do not produce cash.
– Capitalising expenses that cause a cash outflow, eg property
maintenance, R&D.

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How to detect these?

 Read the balance sheet, paying close attention to the

notes to the accounts.
– Accounting standards do give some firms flexibility in where they
report items, but any item that is material must be reported
somewhere.
 Look at the accounting policies used. These must be
disclosed, when in doubt consult with a senior colleague.
 Look at the cash flows: “Cash is king”
 Simple cross checks “sanity checks”
– Does this seem “right” for this company/industry?
– Are increasing sales resulting in increased profits?

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 Structure of your response to Case studies in tutorials
In your tutorials you will be asked to reply to case studies. You are required to employ the following
structure
Facts of the case:
A couple of lines introducing the customer

Key Ratios and Variables: one to two lines each. Up or down and trends.
Sales; Gross Margin; Net Margin; Gearing Ratio; Interest Cover.

Concerns
Record only your concerns about the customer. This will help you to structure your reply.

Decision
Commit yourself and say yes if you are willing to lend subject to certain criteria. State what these criteria
are. The decision should follow logically from your concerns.

Finally go over CAMPARI and check whether you adequately covered all the salient points. If not see
include such info in the relevant section.

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