Textbook PTTDCV

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© Milind Satlwc, James Bartle, Michael Vincent,

Ray Borb 2003
National Library of Australia

Cataloguing-in-Publication data
Credit analysis and lending management.
Includes index.
[SBN 0 470 80041 O.
1. Credit. 2. Credit - Management. 3. Loans.

4. Risk management. l. Sathye, Milind.
332.7
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10 9 8 7 6 5 4 3 2 1
Part1 Part6
Overview Currentissues
1. Theprinciplesof lendingandlending 14. Electronicbankingandlending 413
basics 3
15. Marketingof loans 442
16. Futuredirections 479
Part2
Analysis andinterpretation
of
Part7
creditrisk
Casestudies
2. Financialstatementsanalysis 45
Casestudy1 - BoatBuildersPty Ltd 499
3. Creditscoringtechniques 88
Casestudy2 - Financialanalysisof Boat
4. Creditrisk analysis- an introduction 108 BuildersPty Ltd 507
Casestudy3 - OrbitalEngineCorporation
Part3 Ltd 512
Consumer
lending Casestudy4 - VeterinaryClinicPty Ltd 516
5. Consumerlending 137 Casestudy5 - Creditrisk of majorAustralian
6. Realestatelending 174 banks 522
7. Security,consumercreditlegislationand
legalaspectsof lending 205 Glossary 525
Index 533
Part4
Corporate
andbusiness
lending
8. Corporatelending 241
9. Smallbusinesslending 266
10. Internationallending 311
Part5
Assessment
andmanagement
ofrisk
11. Creditrisk measurementandmanagement
of the loanportfolio 335
12. Creditrisk from the regulator's
perspective 370
13. Problemloanmanagement 389
Part2
Analysisandinterpretation
of
Aboutthe authors xiii
creditrisk
Acknowledgementsxv Chapter2: Financialstatementsanalysis 45
Introduction 46
Whylendersanalysefinancialstatements 47
Part1 Analysisof financialstatements 49
Overview Cross-sectionaltechniques 49
Timeseriestechniques 60
Chapter1: Theprinciplesof lendingand Combiningfinancialstatementandnonfinancial
lendingbasics 3 statementinformation 61
Techniques
ofanalysisusedin projectfinance 63
Introduction 4
Thepaybackperiod 63
Theprinciplesof goodlending 5 Theaccountingrateof return 63
Safetyof loan 5 Discountedcashflowtechniques 63
Suitabilityof loanpurpose 5 Projectrisk analysis 65
Profitability 5 Step-by-stepapproachto financialstatements
Followingthe lendingprinciples- credit analysis 69
analysis 5 Step1: obtainrelevantfinancialstatements 69
Aframeworkfor creditandlendingdecisions 18 Step2: checkfor consistency 70
Externalfactorsaffectinglendingdecisions 19 Step3: undertakepreliminaryscrutiny 70
Lendinginstitution-specificfactors 20 Step4: collectdataaboutindustryandgeneral
Borrower-specificfactors 20 economictrends 71
Step5: conducta comparisonwith industry
Thelendingprocess 21 averages 72
Characteristics
of differenttypesof advance 28 Step6: do supplementaryanalysis 72
Traditionaltypesof advance 29 Step7: summarisethe mainfeatures 72
Modernforms of advancefor businesses 31 Detectingwindowdressing,fraudsand
errors 73
Differenttypesof borrower 33 Useof financialratiosby loanofficers 78
Personalborrowers 33
Limitationsof financialstatementsanalysis 83
Businessborrowers 35
Specialtypesof borrower 36
Summary 84
Keyterms 84
Structuringof advances 37
Discussionquestions 85
Security 37
Debtcovenants 37
References andfurtherreading 86
Pricingissues 37
Chapter3: Creditscoringtechniques 88
Creditculture 38
Introduction 89
Designinganadvancesportfolio 39 Overview 89
Summary 39 Thedevelopment of statisticalcreditscoring 90
Keyterms 41 Thebehaviouralaspectsof creditscoring 91
Theimperativefor creditscoring 92
Statisticalcreditscoringtechniquesversus
References
andfurtherreading 41 traditionaljudgementalmethods 94
Statisticaldecision-making
methodsusedin Legalaspectsof consumercredit 160
creditscoringmodels 96 TheUniformConsumerCreditCode 160
Socialandethicalissuesin applyingcreditscoring Anti-discrimination
laws 161
techniques 101 Thecodeof bankingpractice 161
Implementingcreditscoringwithinthe Tradepracticeslegislation 161
organisation 102
TheAustralianSecuritiesandInvestments
Summary 105 Commission 161
Keyterms 106 Privacylegislation 162
Discussionquestions 106 Trendsin consumercredit 162
Referencesandfurtherreading 107 Trendsin personallending 163
Trendsin creditcardlending 164
Chapter4: Creditriskanalysis- Theimpactof technology 166
anintroduction108 Pricingandstructuringof consumerloans 166
Loanpricing 167
Introduction 109 Loanstructuring 168
Whatis creditrisk? 109 Summary 169
Howdo weanalysecreditrisk? 110 Keyterms 171
Expertsystems 110
Riskpremiumanalysis 115
Referencesandfurtherreading 173
Econometricanalysis 120
Hybridsystems 123
Chapter6: Realestatelending 174
Puttingit all together 124
Usingthefive Cs 125 Introduction 175
Market-basedpremiums 127 Evaluatingrealestateloanapplications 177
AltmanZ score 128 Homeloanbasics 177
Summary 131 Valuationof property 179
Step-by-stepevaluationof homeloans 183
Keyterms 132
Financialappraisalof realestateloans 185
Exampleof a realestateloanapplication 186
Referencesandfurtherreading 134 Precautionsin grantingrealestateloans 188
Trendsin realestatecredit 190
Part3 Trendsin homelending 191
Consumer
lending Pricingandstructuringof realestateloans 191
Loanpricing 192
Chapter5: Consumer
lending 137
Loanstructuring 195
Introduction 138 Summary 201
Typesof consumerloan 139 Keyterms 202
Personalloans 140 Discussionquestions 202
Creditcardloans 142 Referencesandfurtherreading 203
Evaluatingconsumerloanapplications 146
Generalprinciples 146 Chapter7: Security,consumercredit
Step-by-stepassessmentof personalloans 148 legislationandlegalaspectsoflending 205
Step-by-stepassessmentof creditcardloans 151
Introduction 206
Exampleof a consumerloanapplication 152
Personalloans 152 Overviewof the legalframeworkfor consumer
andrealestateloans 206
Creditcardloans 153
Contractlaw:examiningthecapacityto
Precautionsto betakenin grantingconsumer contract 207
loans 154 Consentundertheprivacylaw 207
Creditscoringconsumerloanapplications 155 TheUniformConsumerCreditCode 209
Tradepracticeslegislation 211 Thepurposeof corporatelending 243
Legislationdealingwith contractsand Theloanportfolio 243
consumers 212
Theprinciplesof corporatelending 244
Loandocumentation 212 Methodsof lendingassessment 245
Promissorynote 213 Thelendingcycle 247
Mortgagedeed 213 Structuringthe loanproposal 250
Guarantees 213 Productstructureandapplication 252
Bill of sale 214 Creditratingagencies 254
An assignmentof sharesor life policies 214
Skillsrequiredof the loanofficer 255
Loanagreementform settingout the terms and
conditionsof the loan 215 Theimportanceof financialstatements 256
Executionof documents 216 Managingthe loanportfolio 257
Specialrights of lendingbankers 219 Whatcango wrong? 257
Banker'Slien 219 Advicefrom the past 261
Theright to set-offandthe right to appropriate Summary 263
payments 220 Keyterms 264
Legalrequirementsspecificto homeloans 220 Discussionquestions 264
Property 220 Referencesandfurtherreading 265
Realestate 220
Interestin realestate 222 Chapter9: Smallbusiness
lending 266
Encumbrances andliens 222
Foreclosure 222
Introduction 267
Statuteof limitations 223 An overviewof smallbusinesslending 267
Whatis smallbusiness? 267
Otherrelevantlegalrequirementsin
lending 223 Smallbusinessin the economy 268
Legalissuesaffectingoverdraftsandcredit Somecharacteristicsof smallbusiness
cards 223 lending 269
Howlendersorganisetheir smallbusiness
Creditreferencesaboutcustomers 224 lending 272
Undueinfluence,duress,coercionandcompulsion Competitionin the smallbusinesslending
in banklending 224
market 275
Anti-discriminationlaw 225
Smallbusinessattitudesto lenders 276
TheBankruptcyAct 227 Thepoliticalimportanceof smallbusinessand
Environmentalissuesandlending smallbusinesslending 280
institutions 228
A theoreticalbasisfor understandinglendingto
Codeof BankingPractice 228 smallbusiness 285
AustralianBankingIndustryOmbudsman 228
Thedecisionto lendto smallbusiness 288
AustralianSecuritiesandInvestments
Commission 229 Specialisedrisks associatedwith lendingto small
business 288
Checklistfor lendingofficers 230 Twoapproachesto smallbusinesslending 294
Summary 234 Therelationshipmanagementapproach 294
Keyterms 235 Thecreditscoringapproach 302
Discussionquestions 236 Summary 307
References andfurtherreading 236 Keyterms 308
Part4 Referencesandfurther reading 309
Corporate
andbusiness
lending Chapter10:International
lending 311
Chapter8: Corporate
lending 241 Introduction 312
Introduction 242 Overviewof internationallending 312
An overviewof corporatelending 242 Internationalfinancialsystem 312
countryrisk analysisandinternationalcredit Chapter12: Creditriskfromtheregulator's
evaluation 313 perspective370
Tradefinance 315
Introduction 371
Methodsof paymentandfinancing
techniques 316 Capitaladequacy 372
Uniformcustomsandpracticefor documentary Largecreditexposures 374
credits 325 Securitisation 375
Internationallendingprinciples 325 Cleansalesupplyof assets 375
Safety 326 Revolvingfacilities 376
Security 327 Creditderivatives 376
Suitability 329 Developments in regulation 377
Profitability 329 Creditratings 378
Liabilities 329 Businessrisk 380
Bankguarantees 330 BaselII 382
Summary 331 Summary 385
Keyterms 331 Keyterms 386
Discussionquestions 332 Discussionquestions 386
Referencesandfurtherreading 332 Referencesandfurtherreading 388
Part5
Chapter13:Problemloanmanagement389
Assessment
andmanagement
Introduction 390
of risk
Causesof default 390
Chapter11:Creditriskmeasurementand Theextentof problemloans 391
management oftheloanportfolio 335 Thebusinesscycle 393
Introduction 336 Recoveryandexpansion 393
Creditrisk measurement336 Boom 394
Downturn 394
Altman'sZ score 337
Usingstockprices 341 Problemloans,provisionsandregulatory
issues 394
Portfoliomanagement344 Specificprovisions 395
Risk-adjusted
returnon capital 345 Generalprovisions 395
Altman'sSharpeIndexapproach 347 Baddebtwrite-offs 396
CreditMetrics™348 Regulatoryissues 396
Managingthe portfolio 352 Otherconsiderationswith problemloans 397
Securitisation 352 Dynamicprovisioning 398
Creditderivatives 355
Dealingwith defaults 399
Loanpricing 358 Mildfinancialdistress 400
Costsof the statementof financialpOSition 359 Moderatefinancialdistress 401
Noncreditrisk costs 359 Severefinancialdistress 402
Creditcosts 360 Thecoordinationproblem 403
Loanpricing- anexample 361 Otherbreaches 405
Practicalloanpricing 363 Examplesfrom the law 406
Summary 366 Summary 407
Keyterms 366 Keyterms 408
Discussionquestions 367 Discussionquestions 409
Referencesandfurtherreading 369 Referencesandfurtherreading 409
Part6 Discussionquestions 477
Referencesandfurtherreading 478
Currentissues
Chapter
14:Electronic
banking
andlending 413 Chapter16:Futuredirections479
Introduction 414 Introduction 480
Whatis electronicbanking? 414 Financialintermediation 480
Theevolutionof electronicbanking 415 Banklending 481
Electronicpaymentsystems 417 Thelendingfunction 482
Electronicbanking 419 Thenewlenders 483
Trendsandissuesin electronicbankingand Superannuationandotherfunds 484
lendingin Australia 420 Nonbankinstitutions 485
Trendsandissuesin retailfinancialservices Insurancecompanies 486
technology 420
Useof electronicsystemsfor lending 427
Thenewinstruments 486
Creditderivatives 487
Technology-driven innovationin Australia's
financialservicessector 432 Securitisation 487
Applicationof wholesaleproductsto retail
Regulatoryandrisk managementissuesin customers 488
electronicbankingandlending 435
Complexstructures 489
Theboardandmanagement 435
Securitycontrols 436 Creditmarkets 489
Legaland reputationalrisk management 437 Securitisation 490
Transferableloancertificates 490
A futuristicviewof electronicbanking 438
Loansales 490
Summary 439
Globalisation 491
Keyterms 440
Regulation 492
Theeffectsof electronicbanking 493
Summary 493
Chapter15:Marketingofloans 442 Keyterms 495
Introduction 443
Roleof marketingin financialinstitutions 443
Marketanalysis 444
Screeningthe wholesaleor corporatemarket 445
Screeningthe retailmarket 446 Part7
SWOTanalysis 450 Casestudies
Analysisof retailbankingneeds 454
Casestudy1 - BoatBuildersPtyLtd 499
Analysisof wholesalebankingneeds 455
Productdevelopmentandmarketing Casestudy2 - FinancialanalysisofBoat
strategy 457 BuildersPtyLtd 507
Productpricingstrategy 461 Casestudy3 - OrbitalEngineCorporation
Estimatingcost structure 462
Ltd 512
Deliverysystemstrategy 464
Typesof deliverysystem 465 Casestudy4 - VeterinaryClinicPtyLtd 516
Communicationsstrategy 468 Casestudy5 - CreditriskofmajorAustralian
Advertising 470 banks 522
Promotionsand publicrelations 472
Personalselling 472
Summary 475 Glossary 525
Keyterms 477 Index 533
Lending constitutes one of the most important functions of any financial
institution. In a typical bank nearly 70 per cent of assets are invested in
only one type of asset: loans and advances. If the lending function is
not managed properly, it could lead to credit quality problems and even-
tually threaten the existence of the financial institution. No wonder
stakeholders such as governments, the central bank, regulatory author-
ities (such as the Australian Prudential Regulation Authority) share-
holders, analysts and the general public carefully watch the quality of
the loan portfolio of any financial institution. Committees reviewing the
financial system in any country invariably refer to the problem of credit
quality. To manage the lending function properly and to mitigate credit
quality problems, adequately trained staff are required. In Australia, the
Martin Committee stated back in 1991 that 'banks should ensure that
their assessment of risk and other related areas such as ability to repay
are thoroughly investigated ... Bank loan officers should be adequately
trained in risk assessment techniques'. Many Australian universities
subsequently introduced courses (variously called 'Credit Risk Manage-
ment', 'Credit and Lending Decisions' and so on) that impart the know-
ledge and skills required for credit risk analysis.
Despite these courses having been run for some years now, no single
textbook has been available that covers the credit risk analysis and
lending management function in a comprehensive and complete
manner. As a result, academics have often supplemented their teaching
with reading material drawn from several sources, making it hard for stu-
dents to grasp this material where the essential concepts and their appli-
cation are not explained in a cohesive manner. This textbook addresses
this long-felt need of academics and students in the Australasian region.
Credit Analysis and Lending Management is a comprehensive and
complete textbook on credit risk management. It is divided into seven
parts, containing sixteen chapters and five case studies. Parts 1 and 2
present a framework for assessing and managing credit risk. They
include chapters on the principles of lending and lending basics, finan-
cial statements analysis, credit scoring techniques and an introduction
to credit risk analysis. They introduce the various considerations that
are common to all types of lending. Parts 3 and 4 include chapters that
deal with special types of lending: consumer lending, corporate lending,
small business lending and international lending. They also contain a
chapter that deals with the security and other legal aspects relating to
each of these types of lending. Part 5 details credit risk management
and measurement techniques, and problem loan management. Part 6
concludes with an overview of the developments in electronic banking
and the marketing of loans, before considering future directions for the
banking and lending industry. Part 7 contains the case studies.
In writing this book, we draw from our many years of practical
banking and lending experience, as well as our teaching experience in
tertiary institutions. The learning objectives are clearly indicated at the
beginning of each chapter, and the content directly addresses these
II, learning objectives. In writing the content we have developed concepts
in a brick-by-brick manner supplemented by examples. Special features
of this book include 'Industry insights', 'A day in the life of .. .' boxes
written by practising bankers, and the case studies. These establish the
vital link of theory to real-world situations. Another special feature is the
step-by-step assessment of loan proposals, as presented via reference
to actual loan application forms used by one of the major banks in Aus-
tralia (see chapters 5 and 6). This will give students the necessary con-
fidence to work on a lending desk in a financial institution from day one.
Although this book has been written for undergraduate banking stu-
dents in various Australian and overseas universities, we are confident
that junior officers in financial institutions who are unfamiliar with the
,j lending function will find this book useful to begin a career as a loan
officer.
The authors wish to thank all those individuals who reviewed chap-
ters of the manuscript and offered helpful suggestions, particularly Mike
Oborn (Curtin University of Technology) and David Pearse (Manager
Sales and Service, Suncorp Metway Brisbane). We also thank the
authors of the 'A day in the life of .. .' boxes for sharing their real-world
experience in a nutshell to help undergraduate students.
We are confident that this book will be well received by academics
and students in Australian and overseas universities. We would appre-
ciate any suggestions to improve this work.
Milind Sathye
James Bartle
Michael Vincent
Ray Battey
2 September 2002
This book is dedicated to the memory of Milind Sathye's mother,

the late Mrs Parvatibai Sathye.
MILIND SATHYE
Milind Sathye is an adjunct professor at the Southern Cross University,
having previously worked as a senior lecturer at the University of
Southern Queensland before moving to the University of Canberra.
Milind worked for over two decades in a bank. Author of four books and
over fifty papers in international journals and financial newspapers, he
was awarded the ANZ Bank's Research Fellowship as well as the
Asian Development Bank Japan Scholarship. He was nominated for
the 2000 Australian National Teaching Award. Milind has a Master of
Commerce (Bombay) and a PhD (Pune), and is a senior associate of
the Australasian Institute of Banking and Finance. He researches the
area of banking efficiency.
JAMES BARTLE
James Bartle is a visiting fellow at the University of New South Wales
and heads a consulting company that focuses on credit and treasury
risk management. James has over twenty years experience in the
finance industry and has worked in various credit and treasury positions
in the Commonwealth Bank of Australia, KPMG Management Consult-
ants and Bancorp Australia. He spent several years teaching full time.
James's consulting experience has given him exposure to Australian
banks, government and corporates, and he completed aSSignments in
New Zealand, Malaysia and Indonesia. James has a Bachelor of
Econometrics and Master of Finance, both from the University of New
South Wales. His research interests cover innovative methods of risk
measurement, such as value at risk and CreditMetrics, as well as the
advent of credit derivatives.
MICHAEL VINCENT
Michael Vincent is the foundation director of the Australasian Risk
Management Unit at Monash University, and has designed and written
the course doctrine and outlines presently offered. Michael has a
Master of Enterprise Innovation (Swinburne University of Technology),
a Graduate Diploma in Banking and Finance (Canberra Institute of
Technology), a Diploma in Export (Australian Institute of Export), a
Company Directors Diploma (University of New England) and various
memberships (AAIBF Snr, FAIEX, GAICD, AIMM, AFAMI, MAIRM,
MMGA, CMA). He spent twenty-two years in the banking and finance
industry before joining academia, As a practitioner, he gained experi-
ence in all areas of the industry, ranging from bank branches to the
international arena. During the past seven years he developed and con-
ducted courses in risk management, pioneering formal integrated risk
management education within Australia and internationally.
RAYMOND BOFFEY
Ray Boffey is a senior lecturer in finance and banking at Edith Cowan
University, Perth, and also serves on the Western Australian State
Executive of the Australian Institute of Banking and Finance, Between
1991 and 1997, he ran a large number of lending training courses for
the banking industry. The courses were case study based and involved
site visits to borrowers. During his time at Edith Cowan University, Ray
has had periods of leave to work for the Reserve Bank of Australia and
BankWest. Since 2001, Ray's experience in lending has been used as a
director of a Unicredit. Ray has a Master of Science (University of
Western Australia) and is a fellow of the Australian Institute of Banking
and Finance.
,/
The authors and publisher would like to thank the following copyright holders,
organisations and individuals for their permission to reproduce copyright mat-
erial in this book.
Images
p. 15 (left and middle): Sourced from Aegis Equities Research; p. 15 (right):
CANNEX www.cannex.com.au; p. 145: Reserve Bank of Australia and the
Australian Competition and Consumer Commission; pp. 165, 190: Reserve
Bank of Australia; p. 192: Managing Credit Risk: The Next Great Financial
Challenge, J B Caovette © 1998 John Wiley & Sons. Reprinted by permission of
John Wiley & Sons, Inc.; p. 248: from 'Using an Expert System with Inductive
Learning to Evaluate Business Loans' by Michael J. P. Shaw and James A.
Gentry, Financial Management, Autumn 1988, vol. 17, no. 3. Reprinted by per-
mission of the Financial Management Association and the Authors; p. 270:
Reserve Bank of Australia Bulletin 2002; p. 350: Distribution of value for a five
year BBB bond in one year, CreditMetrics(R). Reprinted with the permission of
RiskMetrics Group Inc., a licensee of JP Morgan; p. 429: Screen shot
reproduced with permission of St George; p. 433: Penetration of EFTPOS &
ATM terminals in Australia from the Wallis Report 1997. Copyright Common-
wealth of Australia reproduced by permission; p. 434: Bank expense ratio by
channel, The Wallis Report 1997. Copyright Commonwealth of Australia repro-
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Management and Marketing by D. F. Chan non 1988 © John Wiley & Sons
Limited. Reproduced by permission; p. 482: © 2001 APRA.
Text
Pp. 12-16: John Kavanagh/BRW 11 February 2000 by permission from Jour-
nalists Copyright; p. 23: National Australia Bank; p. 26: Table 1 from 'Can
computers lend?' by P. B. Andrews, Zeta Services from pp. 14-17 A The
Australian Banker, Feb. 1997. Reproduced with permission of the Australasian
Institute of Banking & Finance; p. 50: from Fundamentals of Finance Manage-
ment, by Prasanna Chandra, Tata McGraw-Hili, New Delhi, p. 115, 1993, 2nd
ed. Reproduced with permission of The McGraw-Hili Companies; p. 75: from
Corporate Collapse: The Causes and Symptoms, McGraw-Hili. Copyright 1976.
Reproduced with permission of The McGraw-Hili Companies; pp. 76-7:
T. Sykes, The Bold Riders, pp. 237-8, Allen & Unwin, Sydney; pp. 80-3:
adapted from 'Getting behind the numbers' by Frank di Lorenzo from The RMA
Journal, pp. 51-3, vol. 83, no. 7, www.rmahq.org; pp. 94-5: from Credit Scoring
and Credit Control, by L. C. Thomas, J. N. Crook and P. B. Edelman, Oxford
University Press. Copyright 1992. Reprinted with permission of Oxford Univer-
sity Press; p. 129: S. Aylmer, Australian Financial Review, pp. 141-2, 230:
© Australian Securities and Investments Commission. Reproduced with
permission; p. 145: Reserve Bank of Australia & Australian Competition &
Consumer Commission 2000, Debit and Credit Card Schemes in Australia: A
Study of Interchange Fees and Access, Canberra, p. 18; p. 157: from P. Rose,
Commercial Bank Management, 1999, Irwin McGraw-Hili. Reproduced by
permission of The McGraw-Hili Companies; pp. 158-60: Ken Sloane - Bank
Branch Manager; pp. 163, 164: Lending Finance Catalogue 5671. January
1997, May 1998-1999 and February and September 2000. Australian Bureau of
Statistics. Copyright Commonwealth of Australia. Reproduced with permission;
p. 163: Lending Finance Catalogue 5671. Australian Bureau of Statistics May
1998 and 1999 and February and September 2000. Copyright Commonwealth
of Australia reproduced by permission; pp. 175-6: Tim Boreham, The
Australian, 9 April 2001; p. 189: Benjamin Haslem, The Australian, 17 February
1998; p. 191: Lending Finance Catalogue 5671. May 1998-2000 Australian
Bureau of Statistics. Copyright Commonwealth of Australia reproduced by
permission; p. 191: Reserve Bank of Australia Bulletin 1999; pp. 192, 193:
Managing Credit Risk: The Next Great Financial Challenge, J. B. Caovette
© 1998 John Wiley & Sons. Reprinted by permission of John Wiley & Sons, Inc.;
p. 225: www.lawlink.nsw.gov.au Reproduced with permission of the
Anti-Discrimination Board of NSW; pp. 226-7: © Gayle Bryant, The Age, 13
August 2001; pp. 232-4: Peter Carlin, Chief Executive, Service One Credit
Union; pp. 268, 271: Reserve Bank of Australia Bulletin; pp. 272, 273, 391:
Reserve Bank of Australia; p. 277-8: © Robin Robertson, Australian Financial
Review, 7 August 2001; p. 348: Probability of a credit rating migrations in one
year for a BBB, JP Morgan 1997, CreditMetrics(R). Reprinted with the per-
mission of RiskMetrics Group Inc., a licensee of JP Morgan; p. 349: Distribution
of value of a BBB par bond in one year, JP Morgan 1999, CreditMetrics(R).
Reprinted with the permission of RiskMetrics Group Inc., a licensee of JP
Morgan; p. 349: Example of one-year forward zero curves by credit rating
category, JP Morgan 1997, CreditMetrics (R). Reprinted with the permission of
RiskMetrics Group Inc., a licensee of JP Morgan; p. 350: Calculating volatility in
value due to credit quality changes, JP Morgan 1997, CreditMetrics (R).
Reprinted with the permission of RiskMetrics Group Inc., a licensee of JP
Morgan; pp. 357-8: Tony Boyd, Associate Editor for the Australian Financial
Review, pp. 364-5: Harvey Yu - Portfolio analyst, Portfolio Management,
Group Risk Management, Commonwealth Bank 2001; pp. 367-8: Harvey
Norman 2000 Annual Report; p. 382: Basel Committee on Banking Supervision,
Bank for International Settlements; pp. 383-4: Australian Financial Review, 18
April 2001; p. 387: Westpac Investor Relations; p. 392: B. Clegg, AFR, 1 August
2001; pp. 406-7: Morgan Mellish; pp. 425-6: 'The emerging role of banks in
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Federal Reserve Bank of New York; p. 431-2: Reprinted by permission of the
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Introduction
For a proper understanding of the subject of credit analysis and lending man-
agement, one must acquire a basic knowledge of the principles of lending.
There are several reasons. First, like any other discipline, credit analysis and
lending has evolved over a number of years, as lending officers developed
insights into the various aspects of credit analysis. The principles of lending are
basically these insights that have been acquired. Principles of lending are not,
therefore, theoretical concepts developed in academic institutions; rather, they
have evolved from the practice of lending in the real world. Second, like any
discipline, the lending discipline requires a framework within which lending
officers can operate. The lending principles provide such a framework. Third,
because these principles are deeply rooted in the practice of lending, they have
applications in real-world situations. Finally, lending principles enable us to
study the subject of credit analysis and lending systematically, and they thus
serve to guide appropriate lending decisions.
An important aspect of lending principles is their universal applicability. The
principles are applicable whatever the type of lending, the type of borrower or
the amount borrowed, and wherever (in any region or country) the loan is
granted. Whether the purpose of a loan is for meeting personal needs, financing
small business, financing a dairy activity or financing an export trade, the prin-
ciples of lending still apply. Similarly, whether a borrower is a home buyer, a
small business owner or a giant corporation like BHP Billiton, the assessment of
the lending proposal is still made on the basis of the lending principles. Again,
whether the loan is for an amount of a few thousand dollars or many millions
of dollars, the principles of lending still apply. Lending officers in the United
States, Australia, India, Russia and any other country invariably follow the prin-
ciples of lending.
Does this mean lending is a stereotyped activity? Is there no scope for per-
sonal judgements? On the contrary, lending is often regarded as an art and not
a science. Like any other sphere of art, lending needs much practice, so experi-
ence counts. A top banker in Australia once said that anyone can lend, but it is
lending money and ensuring its repayment in time together with interest that
distinguishes between a good banker and a bad banker. When you make a loan,
you are dealing with people and it is almost impossible to predict how someone
will behave in future. It is important therefore that lenders exercise sound
judgement while granting a loan. Lending principles help a lender to make
sound judgement. Note, however, that the principles are not laws of physical
science that must hold whatever be the case; rather, the principles serve as a
framework within which to make a decision. This is why we say lending is
more akin to art than to science.
In this chapter, we will first explain the various principles of lending. You will
then learn about some of the lending basics, such as the framework for credit
and lending decisions, different types of advance and types of borrower, the
importance of credit culture and, finally, how a lending portfolio is deSigned.
IT Part1: Overview I
Theprinciples
ofgoodlending
According to Weerasooriya (1998), the three basic principles that guide lending
decisions are safety of loan, suitability of loan purpose and profitability.
Safetyof loan
This principle requires that a loan is granted to only that borrower who is con-
sidered safe. A safe borrower is one who is of good character, is financially sound
and has the ability and willingness to repay the loan. In addition, the lender
should account for meeting an unexpected emergency. Such an emergency could
arise when assumptions about the borrower turn out to be wrong, or when cir-
cumstances change so dramatically that assumptions made when the loan is made
do not remain relevant. Lending institutions therefore often require a back-up
for the loan in the form of collateral security. As Weerasooriya (1998) states, the
collateral serves as a safety valve or insurance against unforeseen developments.
Suitabilityofloanpurpose
A loan can be given for any valid purpose. A valid purpose is one that is legal
and conforms to the lending policy of the bank. A bank cannot lend for an
activity that is not legal. Can you imagine a bank giving a loan for an illegal
activity, such as the narcotics trade? It cannot, because such trade is not legal.
Other purposes for which a financial institution cannot lend include gambling.
If a bank starts financing gamblers, then it would soon go into liquidation!
Suitability of purpose is also important for the safety of the loan. If a loan is
granted for an illegal purpose, then the lender may not be able to recover the
money because the case may not stand in any court of law.
A purpose may be perfectly legal and valid, yet a lender may still refuse to
finance it. This may occur where the loan purpose is outside the lending policy
of that institution. Export financing, for example, is a legal and valid purpose,
but may fall outside the lending policy of a building society or a credit union.
Profita
bility
Financial institutions are in the business of lending to earn profits. Lenders will
compare the cost and benefit of a loan before granting it. Interest on loans and
advances is a major source of income for any bank. Lending institutions must
carefully weigh the risks and returns from a possible loan. This raises the issue
of appropriate pricing of loans, as well as that of minimising loan costs.
In summary, safety, suitability and profitability are the three basic principles of
prudent lending. To follow these principles, financial institutions undertake
credit analysis of all loan proposals.
Following
thelendingprinciples
- creditanalysis
Credit analysis can be done by traditional methods and/or modern methods.
Modern methods use technology and thus facilitate faster processing of
proposals. Even if the credit analysis is done by modern methods, however, it
rests on the foundation provided by traditional analysis. One cannot exclude
traditional credit analysis altogether; it must be taken into account. Traditional
approaches comprise three methods of credit assessment: the judgemental
method (also called the expert systems method), the rating method and the
credit scoring method. \Ve will explain the traditional approaches to credit
analysis and then the modern approaches.
Traditional
methodsofcreditanalysiS
The purpose of any credit assessment or analysis is the measurement of credit
risk. According to De Lucia and Peters (1993), borrowers' credit assessment is
done using the following criteria, popularly known as the five Cs of lending:
• character • collateral
• capacity • conditions.
• capital
Some authors combine capacity and capital, and conditions and collateral
to have just three Cs of lending. The fact remains that credit assessment
considers all the above factors; combining some of the Cs does not exclude
them from consideration. Also remember that these five Cs of lending are
applicable whether the loan is made to a personal borrower or business bor-
rower. We will refer to these Cs of credit assessment throughout this book.
Weerasooriya (1998) suggests adding one more C to the list: compliance.
This means compliance with various statutes and regulations, particularly
the Uniform Consumer Credit Code. We support Weerasooriya's observation
because it puts the credit analysis in its proper perspective. The details of
legal aspects with which lenders have to comply can be found in chapter 7.
We will now explain each of the traditional five Cs and how their analysis
helps a financial institution in judging the safety, suitability and profitability of
a loan.
Character
Character is perhaps the most important and, at the same time, the most diffi-
cult criterion to assess. The famous American banker, Pierpoint Morgan, once
said: 'the first thing I look for is the borrower's character. [ consider that more
important than money or property or even before money or property or any-
thing else. Money cannot buy character. A person I do not trust could not get
money from me on all the bonds in Christendom ... I have known a man to
come into my office and I have given him a cheque for a million dollars when I
knew hc had not a cent in the world' (Weerasooriya 1998, p. 99). There is no
more powerful statement than this, which highlights the importance of char-
acter in the assessment of credit. What is character? Character is the sum total
of human qualities of honesty, integrity, morality and so on. The Macquarie
Dictiollary defines character as 'the aggregate of qualities that distinguishes one
person or thing from others'. Lenders want to know whether borrowers are
morally honest or tricky, industrious or lazy, prudent or speculative, thrifty or
I 6 Part1: Overview I
spendthrift, and whether they have other such qualities. These qualities
combined constitute the character of the borrower. A person who is not honest
represents a risky proposition for a lender, who will not know whether the
money borrowed has been put to the stated use. This author, while working as
a lending banker, encountered a borrower who borrowed money for farm
improvement but used it to construct a farmhouse. The loan was to be repaid
out of excess income to be generated by the farm improvement, but it was
diverted for unproductive use. The borrower repeatedly promised that he would
soon repay the loan used for the farmhouse, but which banker would believe
such a promise?
Character is like glass. Once it is broken, it cannot be repaired. Even if
repaired, the marks of such a repair are always present. Some people with high
positions in public life have had to leave the position when their character came
into question. Dishonesty can lead to disgrace. For this reason, preserving one's
character is vital.
Given the importance of character in general and in a lending situation in
particular, how should one assess character? Character is subjective; further, it
represents different notions in different cultures. What is considered as good
character in one culture may not be so regarded in other cultures. A lender
needs to account for these aspects while assessing character. The lending
banker is concerned with the financial character of the borrower - that is, does
the borrower exhibit honesty and moral integrity in matters of finance? Many
times, it is hard to draw a line between financial character and general char-
acter. It is hard to believe that a person who is dishonest in general life would
be honest in financial matters, so the total character of a person does matter for
a lender. A lender must judge which of the information received about a bor-
rower's character is material and which can be ignored. Given this subjectivity;
how do lenders assess character?
Character assessment involves collecting information about the borrower's
track record of integrity, repayment ability and spending habits. Such infor-
mation is collected not only in personal loans, but also in business loans. In
personal loans, character assessment may seem quite straightforward because
information is collected on only one or maybe two individuals. For business
loans, character assessment involves analysiS of the character of all the owners
and managers of the business. In the case of a partnership, it involves assessing
the character of all the partners of the firm. In the case of joint stock companies
(called public companies in Australia), the character of the directors of the
company is assessed, and in the case of a charitable trust, that of the trustees is
assessed.
Assessment of a borrower's track record should not be a problem if the bor-
rower is an existing customer of the bank. If the customer has been a previous
borrower, then his/her performance in loan repayment could be a good indi-
cation of the character of the borrower. Was the customer prompt in repay-
ment? Or was the bank required to follow up to get repayment? If a corporation
has taken an overdraft, were all the proceeds of the business routed through the
overdraft account? If not, why not? These and other such questions can help
the lender in assessing the character of the prospective borrower. Throughout
this book, you will find various types of character-related question asked by
lenders of prospective borrowers. Lending is all about asking the right ques-
tions and finding the true answers. The character questions that need to be
asked [or personal loans arc fairly simple compared with those for business
loans, for \vhich many more issues need to be considered.
Assessment of character for personal loans is not hard. Personal loans -
such as credit cards, home loans and car loans - are granted to individuals, so
character assessment centres around the honesty and integrity of that individual
or group of individuals. Assessment is generally undertaken by one or more of
the following means:
• If the individual is a customer of the bank, then information about him/her is
already with the bank. The credit history and dealings provide an indication
of the individual's character. Has the customer previously borrowed from the
bank? If so, did he/she repay the loan in time! Was the lender required to
follo\v up to ensure repayment? Ho\v were the customer's dealings with the
bank generally? If the information received in response to these questions is
positive, then the lender will conclude that the character of the party is good.
Where the borrower is new and not a previous client of the bank, the lending
officer should collect information from the customer's existing bankers.
• In the case of an applicant who is a salaried employee, the lender contacts
the applicant's employers and seeks confidential information about the
employee, particularly anything adverse. The bank must be careful while
making such a contact and should not reveal any details about the customer,
which could constitute a breach of confidentiality and secrecy obligations.
The lending officer should collect information in a more general manner.
• The bank may contact friends and relatives of the prospective borrower to
ascertain the character of the borrower. Similarly, lenders often require
borrowers to indicate referees, who can be contacted by the lender for a
character reference.
• Confidential reports from credit rating agencies are another source. In
Australia, Credit Advantage (formerly, the Credit Rating Agency of Australia),
for example, provides confidential reports about the character of the borrower.
An individual can seek a report on hislher own credit rating from this agency,
free of charge.
• Lenders often obtain documentary evidence such as salary statements, group
certificates and a driver's licence so as to establish the identity of the borrower.
When the borrower holds a valid driving licence, it establishes that he/she has
not been involved in any offence and thus confirms good character. Similarly,
a salary statement shows that the customer has a job and obviously is of good
character, or no-one would have employed him/her. Australian banks usually
require the following documents as an identity check: a driver's licence, a birth
certificate, a credit card, a passport or a rates notice.
I 8 ParI1: Overview I
For business borrowers, character assessment involves assessing the char-
acter of the business owners or, in the case of companies, the members of the
board. Sources of information that help lender's conduct a character assessment
include:
• Dun &: Bradstreet journals and their company reporting service
• bank opinion. If the prospective borrower is a customer of another bank,
then a report is usually obtained from that bank. Such a report is called 'bank
opinion'. It is carefully worded and general in riature. It can reveal whether
the party (prospective borrower) is financially sound, not so sound or weak.
• the Australian Securities and Investments Commission (ASIC), which can
provide company information for a fee
• reports from market/local knowledge. Information about the prospective
borrower can be obtained from suppliers and customers of the borrower.
Similarly, market inquiries can be made.
• credit reports from Credit Advantage
• the relevant industry association.
Integrity is another quality that is included in the concept of character.
The Macquarie Dictionary defines integrity as a soundness of moral principle
and character, uprightness or honesty. People often say 'take my word for
it', which means he/she will do all that is necessary to keep the word. This
is integrity, which is an important attribute that banks expect to find in a
borrower. If the borrower has integrity, then the lender can be certain that
the promise of repayment will be honoured. Lenders judge integrity by the
track record of the borrower. In the context of businesses, the integrity of
management (the board of directors) is assessed. In the much-publicised
corporate collapse cases of HIH and One. Tel, the integrity of the companies'
management was questioned.
Another attribute of character is the ability of the borrower. 'Ability' refers to
the technical and management skill of the owners. It is quite common to find
that a borrower has strength in one area but a weakness in another. A motor
mechanic, for example, may possess excellent technical skills but lack business
management skills. In such cases, the borrower has to demonstrate how he/she
proposes to address the skill that is lacking. Hire suitable persons? Admit a
partner with suitable skills? The lender is also interested in knowing whether a
successor is being groomed to take over from present owners when they retire.
A final aspect of character is whether the borrower is spendthrift. Company
managements are often criticised by ordinary shareholders for extravagant
spending. High salaries, high business expenses, the use of expensive com-
pany cars and business class travel are some of the indications o·f extravagant
spending.
Capacity
Capacity is the ability to repay the loan together with interest as per the pre-
determined schedule. It depends on two factors: first, the borrower's financial
position should be sound; and second, the borrower must be able to generate
,.
sufficient net income to service the loan repayment. To assess whether the
borrower's financial position is sound, lenders often seek financial data from the
customer. In the case of personal loans, borrowers are often required to give
details of income and expenditure, and the net surplus available for repayment.
The lender also seeks details of the existing assets and liabilities of the
borrower. Assets may consist of property, investment in stocks, managed funds
and/or term deposits. Liabilities may consist of outstanding balances on loans
and credit cards.
In the case of businesses, lenders usually ask for audited financial statements
and projected cashflow to determine the financial soundness or creditworthi-
ness of the business borrower. The lender considers the profitability of the new
venture proposed by the business, as well as the risks involved. Capacity is
about the primary source from which repayment is expected to take place. It is
important to assess the primary sources of loan repayment at the outset.
In the past, banks lent money on the strength of security that the party could
offer for the proposed loan. Over the years, however, lenders have shifted to
lending against cashflow rather than lending against security. There are many
reasons for this shift. If a loan is granted purely on the strength of security, then
the recovery of the loan may involve selling the security. This is a risky propo-
sition, first, because the market value of security may have depleted in the
meantime and, second, because taking possession of security involves a long
legal process, which is often expensive. Further, bank staff have to spend a con-
siderable amount of time and money to realise the security in satisfaction of the
outstanding loan. As a result, lenders have shifted their emphasis from lending
against security to lending on the basis of cashflow. Borrowers are usually
required to submit projected cashflows from which the lender can assess when
repayment will occur and the sources from which it will come. This process
presupposes a realistic construction of cashflow.
Capital
Capital refers to the capital contribution that the borrower proposes to make
in the total investment. An investment is usually financed partly by bank loan
and partly by the capital contribution of the owner. The owner's contribution
is also called the 'owner's margin'. Such a capital contribution is important
from a lender's point of view. It establishes the owner's stake in the project;
the greater the stake of the owner, the greater is the owner's (and thus the
lender's) confidence in the project. Such a project has a high probability of
success, so a lender feels confident about lending for the project. Lending
institutions insist on at least some contribution from owners. Even in personal
loans such as home loans, banks usually require the owner to contribute at
least 20 per cent of the total investment. Where the owner's contribution falls
below this share, lenders usually insist on mortgage insurance. Mortgage
insurance protects the lender in cases where the owner's financial condition is
not strong and the owner is contributing less to the total investment than
required.
I 10 Part1: Overview
Collateral
Collateral is also known as the secondary source of repayment. When a loan
cannot be repaid out of the primary source, lenders usually take possession of
collateral, dispose of it and use the proceeds to set off the outstanding loan
amount. The literal meaning of the word 'collateral' is 'along side'. A security
exists alongside a loan. When a bank grants an overdraft against inventory, then
the inventory is collateral.
In corporate loans, lending institutions are generally reluctant to lend against
a general charge on assets of a limited company, because unforeseen events
could drastically reduce the market value of the company and thus endanger
the recovery of the outstanding loan amount. Lenders therefore generally lend
against a particular asset. It is less complicated to value such a specific security
than to attempt the general valuation of the company. This issue does not arise
with other forms of business such as a sole proprietorship or a partnership,
where the owners are personally responsible for all debt and their personal
assets are also liable for loan repayment.
Lenders look for the following qualities in a security:
• The price of the security should be stable, or not subject to wide fluctuations.
Lenders may not be prepared to lend against highly speculative securities.
Homes, machinery and easily saleable inventories are examples of securities
for which prices can be expected to remain reasonably stable.
• The marketability of the security is another aspect that lenders consider. If
the advance is not repaid, then the security can be sold qUickly and the
proceeds set off against the outstanding loan amount. Lenders would be
prepared to lend against blue-chip securities (company shares that can be
sold quickly, such as the shares of Qantas and the Commonwealth Bank).
• Lenders like a security with a quickly ascertainable price. If the value of a
security is difficult to ascertain, then lenders may be sceptical about its true
value and may consider it too risky. It may be hard for a lending institution
to determine the true value of an antique, for example, because valuation of
such a security may widely differ.
• Durability is another quality that lenders look for in a security. The security
should not deteriorate over time; for example, perishable goods such as
vegetables could easily deteriorate in a few days and may not hold any value
thereafter. Lenders need to be extremely cautious when lending against such
a security.
• Another preferred quality is portability. If the security is qUickly transportable
or portable, then the lender can sell it in another market. If the security is not
portable, then the lender may find it hard to sell that security in the local
market. Land and buildings are examples of securities that are not portable.
It is hard to find a security that possesses all the above qualities, and a lender
is often required to judge an acceptable compromise. Land, for example, may
have stable value over time but it lacks the qualities of portability, ease of valu-
ation and so on. Given the difficulty in determining the value of a security,
financial institutions usually hire the services of an approved valuer.
Conditions
Accord ing to \Veerasooriya (]998). an analysis of condit ions covers external
and internal factors. In our view. it also covers the conditions and terms of the
loan. The riskier the advance the stricter arc the terms and conditions.
Analysis of external and internal factors is important. The external conditions
- the condition of the economy the condition of the relevant industry. the
threat of war and so on - do aflect the repayment of a loan and need to he
considered when a loan is granted. A proposal may be sound and the party may
be creditworthy. but the husiness may not be profitahle if external conditions
arc not favourahle. External evcnts that may affect husiness success incl ude a
dow11lurn in the econom\'. industry-specific problems and international e\Tnts.
The tourism and airline industry in the United States. for example. experienced
a slump in demand due to general reluctance to travc! following attacks on
1 I September 200 I.
Credit analysis must also account for internal conditions. which Illay include
lending policies. the lending hudgct and the availahility of exper! staff to
monitor the loan. A financial institution may decide to follow a restrictive
lending policy. as a result of a funds constrain\. or to expand lending husiness
in particular segments of the market. Credit analysis should take such aspects
into account.
Intense competition in the commercial lending market will soften the impact
on business of the move by the Reserve Bank of Australia (RBA) to tighten
monetary policy. Although the banks and other lenders to business are
expected to pass on the full value of the RBA's 50-basis-point increase 1I1
official cash rates, announced on 2 February, they will have little scope to
adjust their risk ratings.
Businesses have more places to shop around for a loan than ever before, and
lenders that increase their margins to reflect higher bad-deht risk may find their
clients banking elsewhere.
In recent years, the big banks have had to share more and more of the com-
mercial lending market with the regional banks, and in the past year several
nonbank lenders have taken steps to make their long-heralded move into the
business market. 'Our competitors have certainly improved their skills in the
business lending area', says Peter Coleman, general manager of business finan-
cial services at National Australia Bank (N AB), the country's biggest lender to
business.
A report issued this month by the banking industry research group LM
Equities {now Aegis Equities 1 says the big banks have lost market share in the
12 Part1: Overview I
Dun & Bradstreet's
big four banks do the
in aU industry groups. But their
much as 4- percentage points over
has been very aggressive and is picking up

share in the segments; it is qUickly changing its profile from
pure housing much broader base. Westpac has lost share in all
.commercial
.·Leodaritsis from Commonwealth Bank, the banks that have
·. regionals: Colonial Group, 5t George Bank, BankWest,
.. Suncorp Metway. All these banks have added staff and
new products in their commercial divisions. Other
the same direction: Bendigo Bank moved into business
acquisition of two finance companies, Monte Paschi
indicate that the nonbanks have yet to make sig-

commercial market. Groups such as Wizard Financial
. and Financial Directions have launched business loan packages
aimed at borrowers looking for up to $1 million. However, Leodaritsis says that
if they are picking up share it is still too small to register on Dun & Bradstreet's
database.
Coleman of NAB does not accept all the findings of the LM Equities report:
Their research has some limitations, which they acknowledge in their dis-
claimer. The Dun &: Bradstreet data looks at customer relationships does
not look whether there is actually a credit relationship, the size of any loans or
the adequacy of the underlying security. We agree that the market has becomea
lot more competitive, but our own figures tell us that our share has been flat
over the past year, not falling. We have not lost ground'.
Coleman says NAB's view is that the business community will come through
the monetary tightening in good shape. 'We will be reviewing the sensitivity of
our customers to higher rates but we are not stepping back from the aggressive
growth strategy we have pursued for most of the past decade. I would suspect
that the same is true of our competitors.'
A survey of fourteen bank and financial market economists, conducted by the
Bloomberg news service, reveals wide variation in predictions on official cash
rates when the monetary tightening is over. At one end of the scale, Macquarie
Bank and NAB predicted that cash rates would settle at 5.5 per cent (their
present rate) and Westpac predicted 6.5 per cent - an increase of 175 basis
points for the cycle.
(continued)
Coleman says concerns about NAB's asset quality (the financial strength of
the companies to which it has lent money) have been raised several times in
recent years. 'Last year we did a global review of loans over S200000 in
Australia, New Zealand, the US and the UK - we looked at the whole
book. We stress-tested those loans to sec how they would perform if rates
changed. The information we got back has made us comfortable with our
position:
James Price, general manager for business customers at Commonwealth
Bank, says his team will also continue with its aggressive approach to
building share in commercial banking. '\Ve have been developing our skills
in a number of industries, such as agribusiness and retail. We have added
services, such as a business e-commerce facility and a cashflow lending
product, hedging packages and better risk management services. We don't
have any substantial concerns about asset quality and we will continue with
our strategy.'
RBA figures support the bankers' view that higher rates do not present a
serious danger for business. The percentage of impaired assets to total bank
assets is 0.7 per cent - as low as it has been for the past four years. The banks'
general provisioning for bad and doubtful debts has risen only slightly during
the past couple of years.
The rate of growth in business lending has actually slowed from 10.6 per cent
in 1997-98 and 8.3 per cent in 1998-99 to 6.9 per cent for the year to the
end of November 1999. Those figures are modest compared with the 14.6 per
cent growth in lending for hOUSing (for the year to 30 November 1999) and the
18.1 per cent growth in personal borrowing in the same period. Growth in
personal and housing finance is at its highest level for a decade.
RBA Governor Ian Macfarlane made it clear in his monetary policy statement
on 2 February 2000 that 'exceptionally robust' household spending, fuelled by
inexpensive and freely available credit, was the RBA's chief cause of concerl1..
Macfarlane said the RBA expected economic growth to remain strong in the
period ahead, providing business with expansion opportunities at a more
moderate level.
From a customer's point of view, the competitive nature of the market means
that the current period of monetary tightening is different from previous
occasions. Coleman recalls the banking environment of the early 1980s, when
the industry was still highly regulated. At that time, banks allocated finance on
a quota arrangement and, when the RBA put up interest rates, lenders just
turned off the tap for a while. In the early 1990s, when the country was strug-
gling out of recession, the few lenders that actually wanted to operate in the
commercial market had a free hand to adjust risk ratings and impose conditions
on borrowers.
Coleman says: 'Now you work with your customers to help them restructure
their funding arrangements, put risk management strategies in place or introduce
them to the capital markets if they can do a better deal there'. And if the big
14 Part1: Overview
banks do not look after their customers, there are any number of regionals,
finance companies and nonbank lenders ready to swoop.
Financial Directions, a Sydney mortgage originator that has a loan portfolio
of $530 million, started selling to the small-business market in the middle of
1999. Offering loans of up to $1 million, it reports that it is lending $20 million
a month.
The general manager of Financial Directions, Peter White says that small
business owners are prepared to consider financing alternatives because they
often feel their arrangements with banks involve high fees, expensive risk rat-
ings and intrusive audits.
White says: 'What we have to sell is cheap rates. Our establishment fees
are low, there are no regular charges, no risk rating and no audits. There
is no justification for a risk rating if you are lending against residential
security'.
Leodaritsis says lenders such as Financial Directions have been struggling to
establish anything more than a marginal position in the commercial market.
'Some of the commercial lending done by these groups does not show up
because the loans are taken out by the proprietors and are secured by a first
mortgage - they look like owner-occupler housing finance. But even allowing
for that discrepancy, nonbanks have struggled to get into the commercial
market because it takes more than product. Most businesses want cheque and
transaction facilities and a range of product offerings, such as overdrafts, leasing
and trade finance, to meet different needs.'
BUSINESS LOAN BREAKDOWN HOWTHE SECOND TIER FARES FIXED RATE DEALS COST MORE
Share by size - big banks Share by size - regional banks Small business loan - residential secured
30 9.0
8.5
2f 8.0
;- 7.5
22 "§
.c Vi 7.0
'"
]j
ca
:2
18
* 6.5
6.0
14
5.5
10 5.0+-,-,-.-.-...-...-...-...- ....
R 0 R 0 R 0
- Variable - Three·year fixed
Smallllll Medium. Large.

Small!!! Medium. Large.
Source: Aegis Equities Research Source: Aegis Equities Research Source:Cannex
(continued)
_ ..... _II1II74
..· :&
Wizard, which has been one of the most energetic nonbank lenders in the
home loan market, launched a product called Business Pack in mid-1998. The
loan is secured against property and available for loans up to S750000. Its
selling point is a highly flexible redraw facility. The borrower can split the loan
into three accounts and use one of them as an overdraft hy making use of the
unlimited redraw facility.
\Vizard's chief executh'C, Mark Souris, says recent developments in cus-
tomer sen ice and product design have closed the gap bet ween hanks and
nonbank.; '\Ne have had an interactive voice-response telephone service
operating lor some time. That gives customers access to their data and
allo\\'s them to issue instructions. This year we will launch an Internet
service, which will give business customers even more control of their
accounts.
Souris cOllcedes that nonbank lenders cannot compete on the range of
services. 'vVe don't offer a cheque account and we don't have branch trans-
action facilities. But people are paying a premium for those things. They are
going to the bank for conwniellce. Our loans arc cheap and our fees are
low. There arc enough pCllplc \v11o will cop a little inconvenience for a
better deal to make this a viable business for us. Ahout 10 per cent of our
customers are bUSiness bOlTO\\'Crs,'which is a level we are happy with at the
moment.'
Bouris says Wizard will have to commit a much bigger budget to adver-
tising if it wants to increase its market share. He says the same applies to
other nonbank lenders. 'People associate us with home loans. We have to
change that perception, but we will probably wait until we have done a
little more product development before we increase our marketing exposure.'
Not all nonbank lenders are making their pitch to business with cheap,
secured loans. A Sydney group, Exelerate, has developed an unsecured line of
credit, with payments direct to suppliers. Finance rates are pitched at the same
level as secured mortgage rates.
Phil Carden, Exelerate's chief executive, says the system works on the basis
that suppliers that are paid promptly by Exelerate will negotiate trade discounts
for prompt payment. 'In effect, the suppliers are happy to help underwrite the
company's loan because they receive promptness and certainty of payment',
Carden says.
Whether such exotic structures find favour with the small-business market
remains to be seen, hut business borrowers can face the period of monetary
tightening ahead knowing that there is a wider range of funding alternatives
available to them than ever before.
Source: J. Kavanagh 2000, 'Options open for business borrowers', BRW, 11 February, pp. 52-7.
Here ends our discussion of the five Cs of lending. Fundamental to any credit
analysis, the five Cs approach is the traditional approach to credit risk measure-
ment. Also used are modern approaches that measure credit risk with the help
of statistical methods and technology. Subsequent chapters outline details of
these approaches; here, we will briefly explain the modern approaches.
Remember, 'it is hard to draw the line between traditional and new approaches,
especially because many of the better ideas of traditional models are used in the
new models' (Saunders 1999, p. 7). Before we conclude this section, two more
categories of traditional approaches need a mention here: rating systems and
credit scoring systems.
Rating systems
You may be familiar with rating agencies such as Moody's or Standard &:
Poor's. These rating agencies, among others, rate various bonds that are floated
in the capital market. You may also have come across bond ratings termin-
ologies such as AAA, AA, A+ or B. Similar to such bond ratings, US banks
han' developed loan-rating systems. In some countries, these are called health
codes of advances. The ratings or codes are given on a lO-point scale. A rating
of I denotes excellent business credit, superior asset quality, excellent debt
capacity and coverage, excellent management and so on. A rating of 4 may
mean an acceptable credit but with more than average risk, while a rating of 8
would mean unacceptable business credit where even normal repayment could
be in jeopardy.
Credit scoring systems
Credit scoring systems are to be found in all types of credit analysis whether
personal credit or business credit. These systems identify and weigh (on a quan-
titative scale) certain key factors that determine the probability of repayment
default. Cut-offs are usually set to make a decision. The higher the score, the
better is the loan quality and the lower is the risk. Pre-determined points are
allocated for factors such as a stable job, own home and a driver's licence.
Points are awarded depending on the factors present in the loan application,
and then summed. A decision is made based on whether the summed points
exceed a pre-determined cut-off. Subsequent chapters include illustrations of
credit scoring systems.
Modernapproaches
to creditriskmeasurement
The measurement and management of credit risk have undergone a revol-
ution in recent years. The advances in technology have enabled financial
engineers to try new methods of model building and analysis for credit risk
measurement. Several factors have contributed to this recent surge in
technology-based analysis methods. Increased competition in the loan market
necessitated the development of methods that are quicker, more accurate and
more cost-effective. Consumer expectations have increased and most con-
sumers now expect efficient loan approval from financial institutions. Where
lending institutions have been found to be a bit tardy, consumers have shifted
to other institutions. Loyalty is less and less evident among consumers. Banks
now need methods of credit assessment that cater to the changed customer
needs. Also in recent years, bankruptcies and global competition have
increased, so accurate credit analysis has become more important. The tra-
ditional systems were based on expert knowledge only, requiring expensive
and extensive staff training. Further, there was no guarantee that such trained
staff would remain with the institution for long, and skilled staff often
demand high salaries, which push up the fixed cost of making loans. The aim
thus was to reduce lending institutions' dependency on expert staff and
reduce costs by applying technology solutions. Modern approaches help
achieve this aim.
The more commonly used modern approaches to credit analysis include the
following:
• Econometric techniques involve the modelling of the probability of default.
This probability is used as a dependent variable (effect) whose variance is
explained by a set of independent variables (cause). Financial ratios and
other external variables are generally used as independent variables.
Econometric techniques include linear and multiple discriminant analysis,
multiple regression, logit analysis and probit analysis.
• Optimisation models use mathematical programming techniques to minimise
lender error and thus maximise profits.
• Neural networks try to emulate the human decision-making process using
data as used in econometric techniques.
• Hybrid systems involve establishing causal relationships by estimating the
parameters of such relationships. The KMV Corporation's KMV model is an
example of a hybrid system.
A detailed explanation of the above modern approaches can be found in
chapter 11.
Having explained the traditional and modern approaches to credit assess-
ment, we now turn to the framework within which credit and lending decisions
are made. An understanding of the framework is important for making such
decisions systematically.
Aframework
forcreditandlendingdecisions
Credit and lending decisions are made in the light of several factors that have
an impact on such decisions. Credit analysis is not just financial statement
analysis, as some students think. It is a much broader concept. It is important
to understand the framework within which such decisions are made, so in the
search for the woods one does not miss the trees. Figure 1.1 explains the
deciSion-making framework.
The outer most window of figure 1.1 shows the various external influences
on a lending decision - that is, they are outside the control of the lending
institu tion.
18 Part1: Overview
Lending policy
5Cs of
lending
BORROWER-
SPECIFIC FACTORS
INTERNAL FACTORS
FIGURE 1.1 A framework for credit and lending decisions
External
factorsaffectinglendingdecisions
• General law of the land. A financial institution cannot lend for an unlawful
activity (for example, the financing of people-smuggling activity).
• Macroeconomicfactors. The general condition of the economy also affects the
lending decisions. If the economy is in recession, then lending institutions
may think twice before advancing a loan.
• Industry-specific factors. While the economy may be in good shape, a
particular industry may be in trouble. Lending institutions must take
particular care with a loan proposal from a firm in that industry. Such cyclical
fluctuations in an industry are not uncommon. The home building industry
in Australia, for example, has seen such cyclical fluctuations.
• The Reserve Bank Act 1959. The Reserve Bank of Australia, as a central
monetary authority, may issue directions about the purposes for which
loans can be given, the rate of interest and other charges to be levied, the
quantum of loan that should be given and so on. Since deregulation, the
Reserve Bank has given Australian banks a free hand in these matters. If
circumstances demand, however, the Reserve Bank has powers under the
Act to step in and issue suitable directions, with which banks must comply.
Failure to comply could invite heavy penalties. The prudential supervision
/
powers of the Reserve Bank have now been devolved to the Australian
Prudential Regulation Authority, which was established in 1998 as the sole
prudential supervisor of all financial institutions in Australia.
• The Banking Act 1959. Various provisions of this Act have an impact on the
lending decisions of banks. Chapter 7 contains details.
• The Uniform Consumer Credit Code. In the context of consumer loans,
compliance with provisions of the code has become important. Lending
officers have to ensure compliance (explained in chapter 7) because failure to
comply could attract heavy penalties.
• The Australian Securities and Investments Commission Act 1989. In the context
of loans to corporations, compliance with the provisions of this Act is reqUired.
• The Australian Competition and Consumer Commission. The commission may
issue certain directives, with which lending institutions have to ensure
compliance.
As and when loan proposals are received, they are scrutinised to ensure
various regulatory and legislative requirements are met.
The middle window in figure 1.1 is about decision-making factors that are
internal to the lending institution - that is, institution-specific factors.
Lendinginstitution-specific
factors
Besides the external factors, one or more of the following lending institution-
specific factors have an impact on lending and credit decisions:
• The lending policy of the institution. All advances must comply with the
lending policy of the lending institution. If they do not, then lending officers
have to reply to internal audit queries. The lending policy may specify the
types of advance that the institution prefers to grant. Building societies, for
example, may focus on the mortgage lending business, for which they have
already developed a niche. A loan proposal for importing machinery may not
conform with a building society's lending policy.
• The loan budget. Lending institutions prepare an annual lending budget. They
may restrict lending as a result of a shortage of funds or decide to divert
resources to a particular type of lending for strategic reasons. Lending has to
comply with the lending budget decided by the corporate office.
• Staff availability. Lending institutions may decide to restrict their financing if
they have a shortage of skilled staff to appraise and monitor loans.
These and other such internal factors could have an impact on credit and
lending decisions.
Once a loan proposal satisfies the requirements of various external regulations
(as above) and is within the lending policy and loan budget of the financial insti-
tution, borrower-specific factors need to be considered before a lending decision
is made.
Borrower-specific
factors
The borrower-specific factors refer to the five Cs of lending explained earlier in
the chapter. Analysis of the borrower-specific factors is time consuming and
20 Part1: Overview I
requires the lending officer to use judgement. Every borrower is different and
hislher circumstances are different too. As such, lending and credit decisions
have to be based on a consideration of several factors and, most importantly, on
the judgement of the lending officer. The five Cs approach is handy. As already
explained, the lending officer should examine (1) the character of the prospec-
tive borrower from various sources, (2) the capital contribution that the bor-
rower is prepared to make (which shows the stake of the borrower in the
proposed investment), (3) the capacity to repay, (4) the conditions of the loan
and (5) collateral, in case of nonrepayment of loan. Although lenders have
shifted from security-oriented lending to cashflow or project-oriented lending,
they do not ignore the security aspect. There is hardly any lender who will not
obtain some form of security from the borrower. Lenders do give clean loans
(unsecured advances), but only for a limited amount and for selected parties
who have long-term dealings with the bank.
The above framework needs to be kept in mind by every lending officer.
A lending officer making a decision without regard to the above framework is
likely to invite trouble. If external factors such as compliance with the Uniform
Consumer Credit Code are not met, then penalties could result, even jail. Non-
compliance with a bank's internal lending policylbudget may invite strictures in
internal audit and nonadherence to borrower-specific factors may jeopardise the
loan repayments. The lending officer would be held accountable sooner or later.
The framework protects the lending officer, making it easier to defend a decision
if questioned. Loan decisions have been reviewed in courts of law. If the lending
officer acts within the framework, then it would be easy to establish that decisions
were made objectively and without prejudice.
Lending institutions often prepare a lending manual, which they occasionally
update. The manual contains the above framework in one form or the other.
Graduate loan officers should ensure they comply with the loan manual of their
respective institution every time they make a decision to lend.
Thelendingprocess
Despite their knowledge of many aspects of lending, graduate loan officers
often do not know what exact steps must be taken when a borrower requests a
loan. The following sequence of steps developed by Sathye (1997) could help
inexperienced lending officers. The process is applicable for personal and busi-
ness loans alike, although certain details may not be required for certain types
of loan. Sticking to the following ten-step approach helps ensure vital aspects of
credit analysis are not missed:
• Step 1: obtain the prescribed loan application form. Whenever a borrower
approaches for a loan, lending institutions require a loan application form to
be completed. Loan application forms for different types of loan are now
available at lenders' websites and can easily be downloaded. In the case of
personal loans, generally the information required from borrowers for the loan
application forms is similar, although there could be some variation depending
on the purpose of loan. Loan applications for a home loan would be more
exhaustive than the ones for a credit card loan. Specimen forms for loan
applications and the details required are presented in subsequent chapters.
Generally, at this stage the lending officer checks compliance with external
(regulatory and legislative) and internal (lending institution-specific)
requirements. I f the proposed loan does not comply with any of the
requirements, then the lender would advise the borrower that the lending
institution cannot offer finance.
• Step 2: obtain required documents/financial statements. The documents
required from personal borrowers are a driver's licence, an income statement
(salary statement), evidence of income from other sources, details of monthly
expenditure, details of investments and other assets, and details/a quotation
of the asset to be purchased using the loan. Business borrowers must provide
the documents of constitution (such as a partnership deed). In some countries,
companies may need to supply a memorandum and articles of association (no
longer applicable in Australia). Copies of all such documents should be duly
authenticated by an authorised official of the bank and kept on record.
Business borrowers are also required to submit financial statements.
Normally, lenders request a statement of financial position (formerly called a
balance sheet), statement of financial performance (formerly called a profit
and loss statement) and cashflow statement for each of the previous three to
five years. These statements need to be analysed (as discussed in chapter 2).
National Australia Bank has a checklist of documents (figure 1.2) that
applicants for business finance must provide.
• Step 3: check the loan application form and the documents/financial
statements for any obvious inconsistencies. If there are any information gaps,
advise the party to bring additional documents. At this stage, the lending
banker would have formed a preliminary opinion about the granting or
rejecting of the proposal. In subsequent steps, the lender looks for evidence
that either confirms or contradicts the initial opinion.
• Step 4: if all the information has been received and is in order, then the
decision on whether to grant a personal loan would be made at this stage. In
the case of business loans, the lender needs to take a few more steps. An
important step is to visit the business site of the borrower to gain first-hand
knowledge of the borrower's business.
• Step 5: appraise detailed technical, commercial, financial and managerial
aspects of the proposed business borrower. In subsequent chapters, we will
explain some of these aspects.
• Step 6: assess the financial requirements of the borrower (personal or
business). The lending officer can now assess the exact financial needs of the
borrower and the type of finance required.
• Step 7: if the proposal is approved, then send a letter conveying the approval
to the borrower, adviSing him/her to come to the branch to sign documents.
If the proposal is rejected, then inform the borrower, giving suitable reasons.
• Copies of full financial statements for the past three years and any interim
figures certified and signed as correct by the owners/directors (include
director's reports, balance sheet, profit and loss statement and depreciation
schedule)
• Cashflow budget for at least the next twelve months
• Plant and equipment register
• Stock break-up - raw materials, work in progress, finished goods (where
applicable)
• List of debtors by age (for example, currentlthirty/sixty/ninety days) and
amount owing
• List of creditors by age (for example, currentlthirty!sixty/ninety days) and
amount owing
• Copies of last twelve months bank statements for all non-National transaction
accounts and loan accounts
• Copies of taxation returns for the past three years
• Copies of valuation reports for any property offered as security
• List of associated entities, including a family tree of companies in the group
(if applicable)
Further requirements
Additional documentation will be required if the account is in the name of:
• a company or incorporated body - a copy of the Certificate of Incorporation
• a business - a copy ot the Certificate of Registration of the Business Name
or application for same
• an association (unincorporated) - a copy of the document authorising signa-
tories to sign for the association.
FIGURE 1.2 National Australia Bank's checklist for business borrowers

Source: National Australia Bank, www.national.com.au/Business_Solutions/0.1 192.00.html. accessed
2 March 2002.
• Step 8: if the proposal is approved, then ensure that security and other
documents are duly signed before disbursing the loan. Generally, the loan is
disbursed by direct payment to the party from whom the borrower will be
purchasing the goods. I f machinery is being purchased out of the loan, then
the bank generally makes the payment directly to the suppliers. Banks do
this to ensure the loan is used for the nominated purpose.
• Step 9: monitor the account periodically. I f the conditions of the loan require
the borrower to submit periodical statements, then the lending officer must
watch that the statements are being submitted in time.
• Step 10: where the operations in the loan account are not satisfactory - for
example, a 'hard core' has developed in the account - be very cautious and
take steps before the account turns into a problem loan. (A hard core
develops when the outstanding balance in the account remains static and
does not diminish. This happens when repayments have stopped and the
account has no credits.)
By following this ten-step approach, a lending officer can be certain that
nothing has been missed in the process of lending. Most lending institutions
have developed their own lending manuals that explain the details of steps to be
followed. Lending officers should comply with the instructions given in these
manuals.
The following 'Industry insight' contains an article about the role of computers
in the lending process.
hllying a pr<)found impact on how banks per-

way they are perceived by customers. With
appears that the 'people' element is being
replaced by computers. Credit risk assessment
is losing the personal touch.
How dOes credit risk?

Banking has been an activity in which personal contact and judge-
ment have importance. Branch managers and other staff with
credit always been the 'face' of the bank to customers
seeking loans. time, from the point of view of the bank, the same
staff have been which have received and evaluated information on
customer credit '.
InreivIEI£Ion of their staff, banks have built up sophisticated
and review, with checks and balances that are
the risk of error under controL
of risk depends on so many factors it is difficult to
see judge.ment element can be replaced. Experience in dealing
over many years would seem to teach far more than
a learn. For example, if a customer's account is in debit beyond an
approvtclUmit it takes questions to find out why. Is it because the company is
performing poorly and nearing insolvency, or is it because the company is well
managed but it has received some new orders and needs increased assistance?
In such situations the initial information is not enough. It leads to questions,
which in tum lead to judgement.
What can go wrong?

Just the same, there are problems with judgement. For a start, it is subjective
and two or more credit officers could legitimately have different opinions.
for example, should management experience be judged? If a business manager
known to the bank has had long experience in one industry, does this make him
or her a successful manager in a different field? Different credit officers could
easily have conflicting views.
For example,
Skase and other
..
the benefit of hindsight we

wrong.
ement has-beell, wrmed in the first instance, it can
ovettiJ:'1 1 e'(f..credit revieW-prOCesS,In his memoirs the former man-
agingditectof' . c, Bob White, recounts the difficulties an experienced
bank manager ".bringing the dangers involved in a very large property
loan to his bankJ:r:Hi.manager's recommendation that the exposure should be
reconsidered was based on sound lending principles, but it was rejected by the
bank's credit review committee and ultimately by the directors, When the bor-
rower defaulted, the manager's judgement was shown to be correct, but by then
it was too late. The bank had a very large loan write-off that contributed
towards a downgrading in its international credit rating,
S(epli tOWlilrdsa computer solution
Partly in reaction to the errors of judgement that can occur, many banks -
particularly US banks - are now supplementing the judgement of their staff by
using a computerised credit scoring system. Sometimes it appears that the
. ,Human sidejs being replaced completely For example, a heading in a 1995 New
. York Timesarticle goes as far as suggesting that computers are the new face of
banking: 'Need a loan? Ask the computer,.2
That article, and others that have also appeared recently, refer to many US
regional banks and larger banks such as Chemical Bank, which are now using
computerised credit scoring systems. Their use is now widespread, with the
providers of one such system claiming that it alone is being used by 30 per cent
of the top fifty American holding banks. 3
How a credit scoring system works
The credit scoring systems that are being used are, for the most part,
independent consulting firms which then charge a fee for their use. They
developed by making statistical comparisons between companies that fail and
those that succeed, For larger and medium-sized companies, the information that
is looked at is usually financial ratios derived from published financial statements,
For smaller businesses, the information likely to be considered includes charac-
teristics of the owner, particularly past credit history
Whichever approach is used, creditscoring systems take several separate pieces
of information as input. This is processed to develop a Single numerical score
that indicates the credit-worthiness of the customer. For example, one such
system, the Zeta system, uses published financial information to provide a score
that can range from plus 15 to minus 15. The lower the score, the greater the
probability of a customer failing. A Zeta score of zero or less indicates a company
th:iltAustralian banks would normally refuse to lend to because of an unaccept-
ably high probability\of failure. 4
(continued)
The link hetweenthe Zeta score and the risk of failure is indicated by a study
carried out by the American developers of the system. It shows the probability
of failure becoming pronounced and increasing rapidly as the Zeta score moves
below zero (see table A).
This is a useful link because it indicates that the Zeta score can be used as an
indication of the risk of failure. Companies with scores of zero or less are
clearly shown to belong in the 'reject' category.
TABLEA
Zetascore Five-year
cumulative
probabilitY
offailure
10.0 0.4
7.5 0.5
5.0 0.8
2.5 2.2
0.0 7.5
-2.5 20.4
-5.0 30.0
-7.5 38.4
-10.0 53.4
Source: Zeta Services Pty Ltd.
How a credit scoring system can be nsed

In spite of the uses which credit scoring has, it is still an exaggeration to suggest
that credit decisions can be left to computers. This is not only because of the
importance of customer contact. It is also because, even with the most carefully
developed credit scoring system, there is an important place for humaJ;l;t
ment. Any assessment of credit risk must include consideration of in····
factors such as management experience, industry prospects and
position, and each of these can only be assessed using judgement.
What, then, is the place for a credit scoring system? The main use is to act
as a check on the risk grading that has been assigned by the credit officer. If
the assigned risk grading is out of line with a computer-generated score,
there is an indication that the customer should be re-evaluated. For example,
if a customer is given a high grade according to a bank's internal credit
grading system but the computer-provided credit score is in the danger area,
the alarm bells should start ringing. It may he that there are other relevant
matters that are not taken into account in the credit score, such as the
quality of security that the bank holds, but just the same there should bean
immediate re-evaluation and re-consideration of the risk grading.
In addition to acting as a check, computerised credit scores can provide a
backing to risk that are developed using the more traditional
approach. The case of an experienced manager who failed to convince his
26 Part1: Overview
credit committee that a large property loan should be reconsidered was referred
to earlier. He might have succeeded if the support of a reliable computer-
generated credit score had been available.
Advantages of credit scoring
Any properly developed and applied credit scoring system has several advan-
tages. The most significant one, which has already been referred to, is that it
reduces credit risk. By acting as a check on the evaluations carried out by credit
officers, a credit scoring system provides a valuable second opinion. This
reduces the occurrence of loan defaults. As an example, consider the Zeta
scores for former highAlying Australian companies of the 1980s. All of the Zeta
scores are calcuhited from company annual reports that were published between
one and two years the actual failure occurred (see table B).
TABllaB
Company Yearofannual
report Zelascore
Ariadne 1989 -4.83
Bond Corp. 1989 -5.44
Westmex 1989 -2.07
Quintex 1989 -3.63
Source: From 'Can computers lend?' by P.B. Andrews in The Australian Banker,
February 1997. Reproduced with permission of the Australasian Institute of
Banking and Finance.
In all cases the score is clearly within the Zeta critical area of zero or less.
This would have given a clear warning of the likelihood of failure before it actu-
ally happened.
A second advantage is that credit scoring can increase return. The
any bank loan should be related to risk if the bank is going to gain
return on its funds. Credit scoring provides a way to overcome
maintain lower-than-reasonable risk margins on the basis of considerations
such as a long-standing relationship or competitive pressure. If the credit score
indicates that there is greater risk than the bank's risk rating indicates, serious
thought should be given to altering the rating, with a consequent increase in
the risk margin.
A third advantage is a reduction in the rime tal<.ento consider new loan appli-
cations. This is because credit scoring way of culling out the appli-
cations that can be rejected immediately: For example, Hibernia, a US regional
bank, reported that its cost of reviewing commercial loan applications dropped
by two-thirds once it introduced a credit-scoring system. 5
A fourth advantage is that when credit scoring systems are being used there is
often increased lending to small and medium-sized businesses. There is always
a "name' pull towards better-known businesses, just as customers in a
(continued)
supermarket are drawn to better-known brands. Credit scoring helps correct
this bias. A favourable credit score strengthens the case [or a loan to a business
that was previously unknown. For example, Barnetts Banks, another US
regional banking system, reported that credit scoring increased its acceptance
rate for small business loans [rom 47 per cent to 60 per cent."
A fifth advantage is that a poor credit score can lead to corrective action. A
poor score need not mean that existing support should be automatically with-
drawn. Banks can interact with their customers in a number of ways, and one of
these ways is to give advice about steps that need to be taken if support is to be
continued. Apart from reducing the possibility of loan loss, this can lead to a
stronger customer relationship.
Conclusion
No, computers cannot lend! In spite of occasional sensationalism, the tra-
ditional role of the banker is still all important because there are many factors
in a lending situation require judgement. At the same time, however, there
is no ground for complacency because there can be errors in judgement. The
main advantage of a computerised credit scoring system is that these errors can
be reduced because the scores produced in this way can be used as a check on,
as well as support for, credit assessments arrived at in the traditional manner.
There are also other advantages as more accurate credit assessments lead to
more realistic risk margins, thereby contributing directly to bank profitability.
End notes
1. B. White &. C. Clarke 1995, Cheques and Balances: Memoirs of a Banker,
Viking Press, Melbourne, pp. 249-50.
2. New York Times, 18 April 1995, p. Dl.
3. The art of picking losers', Australian Financial Review, 6 November 1995, p. 28.
4. The Zeta system is marketed in Australia by Zeta Services Pty Ltd, 90 MOlmtSt,
North Sydney. .. ...... ...
5. New Yorh Times, 18 April 1995, p. Dl.
6. Nation5 Business, July 1995, p. 75.
Source: P. B. Andrews 1997, 'Can computers lend?', The Australian Banker, February, pp. 14-17.
Reproduced with permission of the Australasian Institute of Banking and Finance.
We have explained the principles of lending, the framework for making

credit and lending decisions, and the process to follow in credit assessment. We
will now explain the various types of advance made by lending institutions in
Australia, and the different types of borrower.
Characteristics
ofdifferenttypesofadvance
Lending institutions grant advances in various forms such as loans, overdrafts,
bills purchased and bills discounted. Banks generally engage in the provision of
short-term and medium-term finance because their liabilities (deposits) are
repayable on demand and, as such, banks cannot afford to lend for longer periods.
28 Part1: Overview
Through securitisation and other such means (such as purchasing long-term lia-
bilities), however, banks can give long-term loans, especially for housing. As
explained in subsequent chapters, securitisation is a process of selling otherwise
unmarketable assets such as loans and other receivables. Assets are bundled into
parcels that are sold to a special trust which in turn issues asset-backed securities
into the market to raise funds to purchase securitised assets.
Traditional
typesofadvance
The different types of advance - bridging loans, credit cards, personal loans,
purchases of bills, advances against trade debtors and so on - are simply
variations of two principal categories: loans and overdrafts. All the different
types of advance can be grouped as either loans or overdrafts. Only a few
types of finance cannot be categorised in this way. We will explain the two
major types of bank finance and then some of the newer forms that do not
fall in these traditional categories.
Loans
The entire amount of a loan is disbursed to the borrower in one lump sum. It,
together with interest, is repayable over a fixed period of time. Loans are
generally repaid by instalment, but lenders normally reserve the right to recall
the entire loan on demand. Interest is charged on outstanding balances on a
daily/monthly/quarterly basis as the loan conditions specify. The security may
be personal or in the form of shares, debentures, government securities, immov-
able property, term deposit receipts, life insurance policies and so on. A distin-
guishing feature of a loan is that it is disbursed in one lump sum and generally
repaid (together with interest) in monthly or quarterly instalments over a
period of time.
Loans classified according to security
Loans can be classified either as secured or unsecured loans. Loans that are
backed by some form of security are called secured loans. Loans are usually
secured against government paper, a term deposit or any other tangible security.
Lending institutions sometimes grant loans, called unsecured loans, that are not
backed by any security.
Loans classified according to type of borrower
Loans can be classified according to the type of borrower. Where the borrower
is an individual or household, we call it a personal loan. Where the loan has
been obtained for carrying on a business activity, we call it a business loan.
Banks sometimes give loans to governments or government business enter-
prises, which we call government loans.
Loans classified according to the term of the loan
Loans are sometimes classified according to the term or period for which they
are granted. Loans granted for periods of up to a year are generally classified as
short-term loans, loans for periods of up to five years are called medium-term
loans and those for longer periods (say, ten or twenty years) are called
long-term loans. Banks usually grant short-term to medium-term loans because
they raise resources (deposits) that are generally for a short period and are
repayable on demand.
Loans classified according to sector
For the purpose of maintaining statistics, loans are sometimes classified
according to the sector for which they are granted - for example, the retail
sector, the manufacturing sector, or mining and quarrying. Such a classification
helps the regulatory authorities to know how credit is flowing in different
sectors of the economy. This breakdown has implications for suitable policy
formulation. The government may find, for example, that credit flow to the
farming sector is dwindling and may persuade the banks to increase the flow of
finance to this vital sector of any economy.
Loans classified according to region
Regulatory authorities may also be concerned about the flow of credit in different
regions of the country. The Commonwealth Government is often interested in
knOWing whether adequate credit is flowing to regional and rural Australia. Simi-
larly, regulatory authorities may be interested in knowing the flow of credit in
different States of the country.
Loans classified according to purpose
Loans can be classified according to the purpose for which they are granted.
There are home loans, bridging loans (granted to bridge the gap between invest-
ment and an approved loan from some other source), commercial loans, per-
sonal loans, vehicle loans and so on.
Lending institutions are usually required to compile statistical returns and
periodically submit them to the Australian Prudential Regulation Authority,
which publishes such data. If you visit the authority'S website, you can access
the statistical information on loans and advances under 'Banking statistics'.
Overdrafts
As opposed to a loan, an overdraft is like a running account. There is neither a
lump sum payment nor a repayment in instalments over a period of time. Instead,
the borrower is allowed to draw cheques on his/her current account up to a cer-
tain limit in excess of the credit balance in the account. The borrower can deposit
money and withdraw money from this overdraft account any number of times.
The lender ensures the debit balance in the account does not exceed the set limit.
Overdrafts are generally given for one year when, depending on the requirement
of the customer, the approved limit for an overdraft may be renewed. Distin-
gUishing features of an overdraft are a running account, a set limit and frequent
deposits and withdrawals in the account.
As already explained, an overdraft occurs when a customer draws cheques in
excess of the credit balance in hislher current account. Overdraft facilities are
allowed for current accounts only. An overdraft is a fluctuating account wherein
the balance may be sometimes in credit and other times in debit. Whereas cheques
drawn on current accounts will be honoured if there is a credit balance in the
I 3D Part1: Overview I
account, cheques from overdrafts will be honoured if the total debit balance in
the account does not exceed a stipulated limit. In a term loan account, a borrower
may be unable to redraw an amount once it is repaid; in an overdraft, however,
he/she can freely deposit and withdraw the amount. A chequebook is usually
issued for an overdraft account, but not for a loan account.
Like loans, overdrafts can also be classified according to security, type of bor-
rower, sector of economy, region and so on. Overdrafts are usually granted for a
short period of time (say, one year), so classification of overdrafts according to
term is not really relevant.
Credit cards are a special form of overdraft. They provide the customer with
a means of obtaining credit if required. Credit cards can be used to purchase
goods and services up to a set limit which is automatically restored if the cus-
tomer pays the stated due amount before the due date. Credit cards are different
from overdrafts in the sense that while an account holder can allow an overdraft
account to remain in credit, a credit card holder generally does not keep a credit
balance on the card account. Chapter 5 contains more details about credit
cards.
Traditionally, lending institutions used loans and overdrafts to meet the
financial requirements of households and businesses. These loan forms are still
being used to meet householders' financial needs. The forms of advance to busi-
nesses, however, have undergone innovations in recent years. Traditional forms
of advance, whether for households or businesses, were explained earlier in the
chapter. The following discussion covers modern forms of advance used to
meet business needs.
Moderntypesofadvanceforbusinesses
The following nontraditional or modern types of advance are used to meet the
financial needs of businesses.
EquitypartiCipation
Equity participation as a method of financing is fairly common in countries
such as Germany. Instead of advancing a loan to meet the financial needs of a
business customer that is a large corporation, the lending institution supplies
equity capital to satisfy the long-term financing needs. As a major shareholder,
the lending institution appoints directors to the board and thus participates in
the decision-making of the company. Instead of charging interest on the loan,
the lender receives dividends on the equity capital contributed and also has a
close watch on the day-to-day activities of the corporate customer. British banks
(and Australian banks too) have largely avoided such forms of financing,
arguing that lending institutions do not have expertise to run disparate types of
business and cannot afford the time of their senior staff. In some cases, the
lending institution may appoint outside experts to represent its interest on the
board of the corporation. Given that these outside experts are appointed by the
financial institution, they are expected to protect the lender's interest.
Loansyndication
Loan syndication involves two or more lenders jOintly meeting the large finan-
cial needs of a corporate customer. The financial needs of a giant corporation
such as Qantas may be so large that a single lender finds it hard to meet those
needs. There could be several reasons for this difficulty: a single lender may not
have resources to meet the financial needs in full; the lender may be interested
in spreading the risk; or the banking regulations may prevent a lender from
advancing large sums of money to a Single borrower. Prudential regulations
require that banks restrict their exposure (loan outstanding) to a single borrower
to less than 15 per cent of their paid-up capital. Given these difficulties, a group
of banks may meet the financial needs of a large corporation jointly by forming
a consortium. One bank acts as the consortium leader and deals with the bor-
rowing party. The consortium leader is paid an agreed commission by the other
banks in the consortium for monitoring the loan, and follows up on their behalf.
Both the equity participation and loan syndication methods of financing are
known as on-balance sheet methods, because the effect of such an advance
appears on the statement of financial position of the lender. If a lender partici-
pates in equity capital of a corporation, then the amount contributed is shown
as an investment on the statement of financial position of the financial insti-
tution. Similarly, syndicated loans appear as loans on the statement of financial
position. Where the funds supplied by the lender to the borrower are not
apparent on the statement of financial position, they are called off-balance
sheet. Equipment leasing and factoring are the two common methods of
off-balance sheet financing.
Equipment
leasing
If a corporation wants to buy capital goods such as oil rigs and aircraft, then it
may take a conventional loan from a bank or enter into an industrial hire pur-
chase (repayable in instalments) contract. Another option is to enter into a
leasing arrangement. A lease is a contract under which the lessor (lender) hires
out specific equipment to a lessee (borrower). The ownership of the equipment
remains with the lender, but the borrower has possession. This is similar to a
tenancy lease, where the landlord (lessor) owns the house but the lessee
(tenant) is in possession. Just as a tenant pays rent to the landlord for use of
premises, the lessee of equipment pays lease rent to the lender. The equipment
is shown as an asset on the statement of financial position of the bank but not
as a loan. The lease rent is income for the lender. Generally, banks establish
special finance and leasing companies that handle this type of business.
Factoring
Factoring is the purchase of debts by a lending institution. The lender pur-
chases the trade debts of a business and pays the business in cash after
deducting commission. This frees the business of the time and worry of col-
lecting trade debts and also makes working capital available for purchases or
other uses by the business. For the lender, the collection of debts is not difficult
I 32 ParI1: Overview I
because most of the debtors purchased would be clients of the lender and, by
buying the debts, the lender acquires the right to recover the debt. Bankers' lien
is general lien, so the lender is in a stronger position than the business concern
to collect the debt.
Before purchasing debts, the lender will scrutinise the list of debtors, delete
any debts that may be hard to collect and purchase the remainder. Subsequent
chapters outline the details of factor services.
Having explained the modern forms of lending, we will now explain the dif-
ferent types of borrower that lending institutions encounter.
Differenttypesofborrower
Lending institutions are required to do business with many types of borrower.
There are broadly two types: personal borrowers and business borrowers. There
are also some special types of borrower. We will explain all of these types in the
following sections.
Personal
borrowers
Personal borrowers can be individuals, households and families. It is important
to ensure personal borrowers have the capacity to contract - that is, the legal
entitlement to enter into a loan contract. Minors, persons of unsound mind and
undischarged insolvents do not have the capacity to contract.
Minors
A minor is a person who has not attained 18 years of age. Contracts entered
into by minors cannot be enforced, even after the individuals attain majority,
unless they choose to ratify the particular contract. A minor cannot be com-
pelled to repay the money that he/she borrows. Any security pledged by a
minor is invalid and has to be returned to the minor. Financial institutions
should not grant an advance to a minor, even against a term deposit in the
minor's name. An advance made to a minor against the guarantee of a third
party (a major) cannot be recovered from that party. Given that a minor is not
liable as a principal debtor, both the original agreement and the ancillary agree-
ment of guarantee are invalid. A minor cannot be liable on a bill of exchange or
a cheque. The bill or cheque, however, is not invalid merely for having been
drawn by a minor, and other parties to the bill are liable. A minor cannot be a
business partner although can be admitted to the benefits of partnership with
the consent of all the partners.
Personsofunsound
mind
If a person of unsound mind can prove that he/she was so at the time of
entering into a loan contract, then the liability under the contract can be
avoided. Whenever a bank receives an express notice of a customer's psychiatric
disability, the bank usually stops all operation on the account and awaits a court
order appointing a receiver.
Insolvents
A financial institution should not lend to an undischarged insolvent or a
person against whom insolvency proceedings are pending. The Bankruptcy Act
1966 (Cwlth) contains some provisions on matters relating to bankrupt
persons. It is applicable to the bankruptcy of individuals only (including joint
proprietors and members of partnerships) and does not apply to corporations.
The action of bankruptcy starts with a debtor's or a creditor's petition. Bank-
ruptcy is deemed to commence immediately after a petition to the effect is
presented. It could commence earlier if an act of bankruptcy was committed
within six months before the date of petition. Bankruptcy has far-reaching
effects on the bankrupt, the property of the bankrupt and anyone who deals
with the bankrupt in six months preceding presentment of the petition. A
bankrupt's property vests with an official trustee appointed by the court.
Once a bank has a notice that a customer has been declared bankrupt, all
credit balances in the customer's account vest with the trustee, although the
bank has a right to set-off under the Bankruptcy Act. A bank faces a problem in
dealing with customers where bankruptcy is known or suspected but notice of
bankruptcy has not been received. As per s. 124 of the Bankruptcy Act, where
the bank has made payment or delivered property in good faith or in the ordi-
nary course of business, and has acted without negligence, such a payment or
delivery will stand untouched by a trustee. The onus of proof in such a case,
however, rests with the bank. Lending bankers need to be circumspect while
dealing with bankrupt persons.
Jointaccounts
A joint account is a bank account conducted in the names of two or more
persons who are not partners, administrators, executors or trustees. A banker
must obtain the joint holders' clear and specific authority regarding one or
more of the parties overdrawing the account, taking an advance or charging a
security An authority to operate the joint account does not extend to the above
matters. As a precaution, bankers usually obtain a joint and several (separate)
demand promissory note Signed by all the holders of the account. In the case of
the death or insolvency of any of the joint account holders, it is advisable for
the bank to stop the operations in the account if it is in debit, making the estate
of the deceased liable for the outstanding debt.
Husband
andwife
The rights and responsibilities of husband and wife are similar to those of other
jOint account holders. Where a loan advance is made to them jOintly, the lender
should obtain a demand promissory note signed by both, acknowledging their
jOint and several (separate) liabilities. A married woman can be held liable only
to the extent of her separate estate. In any case, her husband is not responsible
for the debts incurred by her unless they are for her necessities of life or he
specifically undertakes to repay her debt.
I 34 ParI 1: Overview
Business
borrowers
There are different forms of business and thus different types of business bor-
rower. The following are common types.
Soleproprietorship
A sole proprietorship is a business that an individual owner conducts in his/
her own name or a trade name. Harry Ronald Bruce may trade in the name of
H. R. Bruce and Co., for example, in which case he has to sign as the sole pro-
prietor of the concern. Lenders usually obtain a declaration from the proprietor
that he/she is the sole owner of the business, that no other person has any
interest in the business, and that he/she is personally liable for all dealings and
obligations in the name of the business.
Partnerships
A partnership is a relation between persons who have agreed to share the
profits of a business carried on by all or anyone of them acting for all.
Another name for a partnership is 'firm'. A partner is an agent of the firm for
the purpose of business and can bind the firm. A partner thus has implied
authority. Every partner is liable jointly with all the other partners and also
severally (separately) for all acts of the firm done and instruments executed
while he/she is a partner. This liability applies only where the act is done or
the instrument is executed in the firm's name, and the act/instrument relates
to the kind of business conducted by the firm. A partner cannot bind the firm,
unless specially authorised by the other partners, for a purpose apparently
outside the scope of the ordinary business of the partnership.
A partnership may be dissolved by circumstances provided in the partner-
ship agreement or by the bankruptcy or death of a partner. Each partner is
jointly and severally liable to an unlimited extent for the obligations of the
firm. The property of the firm is first applied for payment of debt and then,
if there is a balance due, the personal property of the partners is liable for
the debt. Lenders must exercise caution while executing documents from
partners. All the documents must be signed by all the partners in their
capacity as partners and also in their individual capacity. A partner has the
power to borrow in the ordinary course of business of the firm, which he/she
is apparently managing. Consequently, a partner has a right to mortgage the
firm's immovable property.
Companies
A company is an artificial person created by law. As a result, a company needs
some natural person to act on its behalf. Such a person is called an authorised
person and has that authority conferred by a speCial resolution from the com-
pany's board of directors. Generally, the managing director and the company
secretary are authorised officials who act on behalf of the company.
Before making an advance to a company (whether proprietary or public),
lenders must ensure there is a resolution to borrow and the borrowing is within
the borrowing powers of the company. Similarly, there has to be suitable authority
for creating a charge on the company's assets. Lenders usually collect confidential
reports about directors, to assess their character before making an advance.
Specialtypesofborrower
Besides households and business borrowers, lenders come across some special
types of borrower that do not fall in any of the above categories. These special
types of borrower - see below - are not individuals or businesses.
local authorities
A local authority such as Toowoomba City Council is created by a special
statute which governs its borrowing powers. A lender should examine the
extent to which the authority can borrow, forms of borrowing authorised,
security that can be offered and whether prior approval of the State Govern-
ment that created the local authority is required. After examining these aspects,
the lender should obtain a resolution from the authority about the amount to be
borrowed and the persons authorised to make application and sign documents
on behalf of the local authority.
Clubs,literarysocietiesandschools
Clubs, literary societies and schools have no legal entity like a company, and
have no powers to enter into contractual relations. As a result, such organ-
isations usually register as unincorporated associations or trusts. A lending
institution should carefully study the bylaws of such organisations, to ascertain
their borrowing powers and purposes for which they can raise money. It should
also examine the persons authorised to raise the money. Generally, the lender
obtains the personal guarantee of the trustee.
Unincorporated
associations
Nontrading associations of persons, such as associations for promoting charity,
arts and religion, may register as unincorporated associations or trusts. Lenders
need to take precautions similar to those for clubs and societies before granting
an advance.
Co-operatives
Co-operative organisations are established for the benefit of members. Such
organisations are registered under the Co-operatives Acts, which are State legiS-
lation. As with clubs and societies, lenders need to study a co-operative's bylaws
before granting any advance.
In the discussion so far, you have learned the principles of lending, the five Cs of
credit assessment, the process of lending and different types of advance and types
of borrower. A lender needs knowledge of these aspects before deciding to approve
an advance. Once the lender decides to grant an advance, the next step is to decide
how to structure the advance. In the following section, you will learn how
advances are structured.
36 Part1: Overview
Structuring
ofadvances
Structuring of an advance involves three major aspects: obtaining security and
other documentation, deciding on the debt covenants and pricing. We will briefly
consider these here. You will also learn more about structuring in subsequent
chapters.
Security
Taking security over a borrower's or third party's assets is like an insurance that
protects the lending banker in unforeseen circumstances. Security is often
referred to as a secondary source of repayment. It is a lender's least preferred
option, however, because realising security is often a costly and time-consuming
process. It also brings negative publicity to the financial institution and the bor-
rower often legally contests the decision to sell security. There are different types
of security, each one having its own specialised documentation. Common forms
of security include:
• land and improvements to land
• guarantees, which are invariably obtained from company directors
• for personal borrowers, an equitable mortgage over assets, or shares and life
policies
• bills of sale, which hire purchase companies use when they provide finance
for motor vehicles
• for farmers, crop lien and stock mortgages.
Debtcovenants
An important part of loan documentation is the loan contract that sets out the
terms and conditions of an advance. The standard covenants included in loan
contracts are:
• fees and interest rates
• any securitylinsurance
• repayments and actions in case of default
• stamp duty and government charges.
To ensure added protection, lenders may impose additional covenants on the
statements of financial position. These include ratios that the business must
maintain for working capital, secured and unsecured liabilities, and minimum
shareholder funds. Sometimes, negative pledges are added to the loan contract.
A negative pledge requires a borrower to undertake not to provide any further
security to another lender, or to do so only on a restricted basis.
Pricingissues
Pricing issues include the interest rates and fees to be charged on advances.
Most lending institutions have a base rate to which they add a margin (called
the risk premium) relative to the risk of the credit. Banks often publish the base
or indicator lending rates. If you refer to any major newspaper in Australia,
you will find such indicator rates. Due to competition in the market, a lender's
base rates of interest align with those of other lending institutions, but the risk
premium is decided on a case-by-case basis. Advances are generally granted
with either fixed rates or variable rates of interest. There are also variations on
these two major types of interest rates.
While interest rates are charged for allOWing the use of money, fees are
charged to cover the costs of administering and monitoring the loan. (The
issues of fees and interest will also be discussed in subsequent chapters.)
Lenders generally charge the following fees:
• an establishment fee
• an application fee
• a loan administration fee
• an unused limit fee.
The above aspects of structuring advances are important at the operational

or branch level. At the corporate level, however, bank management is more
concerned with developing a proper lending (credit) culture within its
organisation, as well as designing a lending portfolio. We will only briefly
discuss these matters; a detailed discussion is beyond the scope of this
book.
Creditculture
Culture means a stratum of linked attitudes, responses and behavioural patterns
within an organisation. Credit culture means the institutional priorities, tra-
ditions and philosophies that surround credit or lending decisions. A cultural
attitude towards credit risk assessment is critical in any credit-granting organ-
isation. According to Caouette, Altman and Narayanan (1998), credit culture
refers to the collection of principles, actions, deterrents and rewards within a
lending organisation. Banc One, for example, works around the following
prinCiples:
• strong customer orientation
• a preference for small exposures
• an understanding of the business to whom you are lending
• an understanding of the organisation's risk tolerance and profit goals when
assessing proposals
• an understanding that avoidance of problem loans is not necessarily a sign of
good performance
• open and direct communication with employees.
Collectively, the above ways of day-to-day working constitute Banc One's credit
culture. When they start in their new jobs, graduate lending officers are made
familiar with the institution's culture through appropriate training programs and
learning from others in the organisation.
Designing
anadvances
portfolio
Around 70 per cent of total assets of a typical financial institution are tied
up in loans and advances, so a major task of top management and the port-
folio manager is to design the institution's loan portfolio. This involves
many strategic management considerations. Here, we will briefly explain the
issues involved.
Top management has several strategic decisions to make in portfolio selection,
including the following:
• What resources are available to invest?
• Of these, what proportion should be invested in advances?
• Of the total resources to be invested in advances, what proportion should be
invested in personal advances and what proportion should be invested in
business advances?
• Of the resources to be invested in personal loans, what proportions should be
invested in credit cards, home loans and so on? (Similar choices need to be
made for business loans.)
Designing a loan portfolio is about finding answers to such questions. Top man-
agements have to weigh the risks and rewards of investing in a particular advances
portfolio and accordingly design the portfolio. Such a well-considered lending
portfolio becomes the corporate lending budget, which is then allocated among
regions and branches.
According to Caouette, Altman and Narayanan (1998), financial institutions
follow three approaches in designing loans and advances portfolios:
1. historical or recent loss experience
2. standards based on maximum loss tolerance relative to capital
3. risk-adjusted return on capital, where the risk is evaluated relative to the
risk either at the transaction level or at the business unit level.
The modern portfolio theory provides a useful framework for a loan portfolio
manager considering risk-return trade-offs. A number of modern portfolio
theory-type techniques have been developed to help portfolio managers in
designing loan portfolios. The important ones include the KMV's Portfolio
Manager, CreditMetrics™, VAR, RAROC and EVA (see subsequent chapters).
Detailed explanation of these models can be found in Credit Risk Measurement
(Saunders 1999).
Summary
1. What are the basic principles governing bank lending? What is their importance?
The basic principles of good lending are safety of loan, suitability of loan
purpose and profitability. Loans should be given to borrowers with good
character and good creditworthiness, for approved purposes, and should
result in profit for the bank.
2. What is the framework within which credit and lending decisions are taken?
Credit and lending decisions are taken within a framework of external factors
such as macroeconomic policies, monetary policies and other regulatory
restrictions; internal factors such as lending institutions' strategic objectives,
lending programs and staff availability; and borrower-specific factors such as
character, capacity, capital, conditions and collateral.
3. What are the various steps involved in the lending process?
All lending proposals are processed following a set procedure. This process
generally consists of receiving an application, verifying details, obtaining
documents, identifying information gaps, making a site visit, judging
viability (technical, commercial, economic and financial viability), approving
or rejecting the proposal, and, if the loan is approved, executing documents,
following up the loan and monitoring repayments. All the steps may not be
required in every case and some steps may be combined.
4. What are the characteristics of various types of bank advance?
There are broadly two types of advance: loans and overdrafts. Loans are
generally made in one lump sum and are repayable by instalment over a
period of time. An overdraft is a running account, which can go into debit
and come back into credit. Business borrowers can also be financed by
modern methods, which include equity participation, equipment leasing, fac-
toring and loan syndications.
5. What are the different types of borrower and what special considerations
apply to them when giving loans?
Principally there are two types of borrower: personal borrowers and business
borrowers. Individuals and households are considered to be personal bor-
rowers. Business borrowers may take many forms, including a sole pro-
prietorship, partnership, limited company and so on. There are also special
types of borrower, such as schools and local councils.
6. How are the advances structured?
Structuring an advance involves three major aspects: obtaining security,
deciding on the debt covenants and pricing.
7. What is the importance of Credit culture in a lending institution?
A credit culture means the institutional priorities, traditions and phil-
osophies that surround credit or lending decisions. A strong credit culture
helps a lending institution manage credit risk effectively and gives it a com-
petitive advantage in the marketplace.
S. How is an advances portfolio designed?
Financial institutions generally follow three approaches in designing loans
and advances portfolios. These approaches include historical or recent loss
experience; standards based on maximum loss tolerance relative to capital;
and risk-adjusted return on capital, where the risk is evaluated relative to the
risk either at the transaction level or at the business unit level.
collateral, p. 5 equity participation, p. 31 negative pledge, p. 37
credit culture, p. 4 factoring, p. 32 overdrafts, p. 28
credit scoring, p. 17 five Cs, p. 6 portability (of security),
debt covenants, p. 37 indicator lending rates, p. 11
durability (of security), p. 37 rating systems, p. 17
p. 11 loan syndication, p. 32 risk premium, p. 37
equipment leasing, p. 32 marketability (of security),
p. 11
uestions
1. What factors have to be taken into account by a bank in conSidering an
application for an advance?
2. What is creditworthiness and how can it be determined?
3. Why do banks require a customer to contribute some of the capital
required for a project?
4. Distinguish between a loan and an overdraft.
S. What are the advantages of a framework for credit and lending
decision-making?
6. What is a credit analysis? What are the various steps involved in a
credit analysis?
7. What does structuring of advances mean?
8. What are the different types of borrower?
9. What is meant by credit culture? Why is it so important?
10. 'Lending is an art, not a science.' Do you agree with this statement?
, -------_. __._-----
References
andfurtherreading
Bathory, A. 1987, The Analysis of Credit, McGraw-Hili, London.
Caouette, J., Altman, E. & Narayanan, P. 1999, Managing Credit Risk: The New Great
Financial Challenge, John Wiley & Sons, New York.
Collett, N. & Schell, C. 1992, Corporate Credit Analysis, Euromoney Books, London.
De Lucia, R. & Peters, J. 1993, Commercial Bank Management, Serendip Publications,
Sydney.
Egginton, D. 1977, Accounting for the Banker, Longman, London.
Koch, T. 1992, Bank Management, Dryden Press, Fort Worth, California.
Sathye, M. 1997, Bank Finance for Cottage, Vii/age and Small Scale Industries, Skylark
Publications, New Delhi, India.
Saunders, A. 1999, Credit Risk Measurement: New Approaches to Value at Risk and
Other Paradigms, John Wiley & Sons, New York.
Stephens, R. 1980, Uses of Financial Information in Bank Lending Decisions, UMI, Ann
Arbor, Michigan.
Weerasooriya, W. 1998, Bank Lending and Securities in Australia, Butterworths, Sydney.
Whiting, D. P. 1979, Elements of Banking, M&E Handbooks, Plymouth, England.
Introduction
In chapter 1 on the principles of lending, you learned that lenders, before
making a lending decision, assess the character, capacity, capital, collateral and
conditions of the prospective borrowers. Lenders use a variety of techniques to
assess these five Cs of lending. To assess character, for example, they may hold
a personal interview with the borrower, obtain market reports, seek a banker's
'opinion' and procure reports from Credit Advantage, among other assessment
techniques. For assessing capacity, capital and collateral, the lending banker's
principal tools are the borrower's financial statements. Interestingly, as you will
learn in subsequent sections, financial statements can also throw light, albeit
discretely, on the character of the borrower. In the recent World Com scam in
the United States, financial statements were manipulated to show a healthy pic-
ture of business performance. Do you think such an act throws light on the
honesty and integrity (character aspects) of the company's management? In
sum, financial statements and their analysis are the basic planks of credit
assessment.
It must be stated at the outset that financial statements analysis is relevant in
business lending, not in personal lending. By law, individuals are not required
to prepare any financial statements. They merely maintain a record of their
income and expenditure, or gains and losses. From these records, the lender
will know their surplus income and whether it is sufficient to repay the loan.
For business borrowers, the situation is different. They are required by law to
keep financial records and prepare financial statements. They may also be
required to have these statements certified by authorised accountants and, in
some cases, to publish them. The law sometimes requires businesses to file such
statements with the concerned statutory authority; for example, every public
limited company has to file a copy of its audited and published accounts with
the Australian Securities and Investments Commission. Besides statutory
authorities, other users of the information (such as shareholders and creditors)
may require financial statements. The lender could be one of the creditors. In
summary, businesses invariably prepare financial statements, which financial
institutions require them to submit along with their loan applications.
The key financial statements used by a lender for analysing the financial
standing of a business firm are:
• a statement of financial performance, also called a profit and loss account,
operating statement or income statement
• a statement of financial position, also called a balance sheet
• a statement of cashflows.
In addition, the law requires public companies to prepare notes to financial
statements, a director's declaration, an auditor's report and a director's report
Oubb, Haswell & Langfield-Smith 2002, p. 49). In your study of financial
accounting, you would have learned how each of these statements is prepared.
It is a good idea to revise the relevant material to help your understanding of
the discussion in this chapter.
I 46 Part2: Analysisandinterpretationof creditrisk I

Lenders invariably obtain financial statements from prospective borrowers
and analyse them. They may not, however, conduct a detailed analysis (as dis-
cussed in this chapter) for every borrower. The financial statements analysis for
a sole proprietor may be fairly basic compared with that for a public limited
company. The analysis is a time-consuming process that requires considerable
skill, yet a financial institution will do some basic financial statement analysis
for all business loans, big or small. Why do lenders place so much importance
on this analysis?
Whylendersanalysefinancialstatements
Lenders analyse financial statements because they help answer the following
three important questions, which are the subject of any credit analysis:
1. Should the bank give the requested loan?
2. If the loan is given, will it be repaid together with interest?
3. What is the financial institution's remedy if the assumptions about the loan
turn out to be wrong?
It is less risky for a lender to give a loan to a business that is financially
sound. But how can a lender know whether a particular business is financially
sound? A sound business possesses the following characteristics:
• The business has adequate liquidity so it can honour short-term obligations
easily.
• The business is run efficiently.
• The business is run profitably.
• The proprietor's stake in the business is high; alternatively, the business is
not burdened with too much debt.
By appropriately analysing financial statements (for example, ratio analysis),
the lender can know whether the above characteristics are present. If they are
present, then the business will be considered to be financially sound and loan
approval will not be a problem.
The second question of whether the loan will be repaid together with
interest is a bit tricky. Financial statements analysis is essentially a post
mortem and cannot provide an answer to this question. The financial state-
ments belong to a period that has already elapsed, but the loan is to be
repaid in the future and no-one knows what the future holds. How can a
lender find an answer to the second question? How can the lender predict
what will happen?
While a lender cannot predict the future with absolute certainty, a reasonable
guess can be made by analysing the following factors:
1. Trend (time series) analysis. If the business was run profitably for some
years, then it may not be unreasonable to assume the trend will continue.
The past trend and the projected surplus, the past trend and the projected
cash surplus, the trend of various ratios and the likelihood of continuing of
that trend are some factors that need to be examined.
-
2. Safety buffer. If the business has a large margin of safety (between actual
sales and break-even sales), then some fluctuations in business conditions in
the future may not be a cause for worry.
3. Stress testing. The business can be subjected to sensitivity testing. If the
business continues to remain profitable, then the lender can be reasonably
certain that the business can withstand shocks in the future.
4. Industry analysis. What are trends and prospects for the firm's industry? If
the industry is growing, then the lender can expect that the firm will also
grow.
5. Economic analysis. The lender can analyse trends in the domestic and inter-
national economies to gauge the possible impact on the business.
The techniques that help the lender in analysing the above factors include: a
projected income and expenditure account, a projected cashflow, margin of
safety analysis, sensitivity analysis, trend analysis, interfirm comparison,
industry analysis and economic analysis. Predicting the future of the business is
just a 'best guess' by the lender; no-one can predict the future with absolute
certainty.
Given that some amount of risk is always involved, the bank needs some
form of insurance. Such an insurance and thus an answer to the third
question - what is the financial institution's remedy if the assumptions
made while giving the loan turn out to be wrong? - are provided by the
following:
1. Collateral. If everything goes wrong, then the banker can fall back on the
security obtained while granting the loan. The bank will sell the security and
use the proceeds to satisfy the outstanding debt.
2. Charge on assets. The lender sometimes prescribes a condition that there will
be a floating charge on all the assets of the business. If the proceeds from the
collateral are insufficient, then the financial institution can stake a claim
over the other assets of the business.
3. Guarantees. The lender will insist on personal guarantees of company direc-
tors so in the case of default the financial institution can recover dues from
the personal property of the directors. Such a guarantee also acts to deter the
company directors from taking actions that are detrimental to business
interests. In sole proprietorships and partnerships, the owners are personally
liable anyway, so the guarantees may be taken from friends or relatives of
the owners.
4. Conditions. The financial institution may place conditions on a loan, such as
a negative pledge (as explained in chapter 1), to ensure the business remains
disciplined and does not take any action that may be detrimental to the
lender's interest.
Financial statements may show what kinds of assets are available, their book
value, whether they are unencumbered (that is, not given as security for other
loans), and the likelihood of these assets being used as security for the
proposed loan.

It should be clear to you now that financial statements analysis and other
types of analysis are used to find answers to the earlier three questions that are
repeated here for ready reference:
I. Should the bank give the requested loan?
2. If the loan is given, will it be repaid together with interest?
3. What is the financial institution's remedy if the assumptions about the loan
turn out to be wrong?
Financial statements contain a wealth of information, but it takes skill and
experience to unearth that information. If properly analysed, the financial state-
ments can provide valuable insights into a firm's performance and financial con-
dition. In the following section, we will discuss how financial statements are
analysed to unearth their hidden information content.
Analysisoffinancialstatements
Financial statements analysis is the principal tool of the lending banker in
assessing the financial performance and condition of any business. Foster
(1986) distinguishes three broad types of analysis technique:
• cross-sectional techniques
• time series techniques
• a combination of financial statement information and nonfinancial statement
information.
We will use the same classification in the following discussion.
Cross-sectional
techniques
Cross-sectional analysis techniques analyse financial statements at a 'point in
time'. Two commonly used techniques are financial ratio analysis and
common-size statements.
Ratioanalysis
A ratio is an arithmetical relationship between two figures. When the figures are
taken from the financial statements, we call it financial ratio analysis, which is
the most widely used cross-sectional technique (Foster 1986). Two financial
statements are generally used for calculating ratios: the statement of financial
position and the statement of financial performance. From these two principal
financial statements, several ratios can be calculated.
The various ratios that lenders generally use can be grouped into the
following categories:
• liquidity ratios
• efficiency ratios
• profitability ratios
• leverage ratios.
Here, we will discuss each of these ratio categories. To facilitate the
discussion, the following statement of financial performance and statement
of financial position will be used.
/" -
City First Saddlery Limited
Statement of financial performance for the year ending 31 March ($'000)
2003 2002
Net sales 70.1 62.3

Cost of goods sold 55.2 47.5
Inventory 42.1
Salary and wages 6.8
Other manufacturing expenses 6.3
Gross profit 14.9 14.8
Operating expenses 5.6 4.9
Depreciation 3.0
General administration 1.2
Selling 1.4
Operating profit 9.3 9.9
Nonoperating surplus/deficit (OA) 0.6
Earnings before interest and tax 8.9 10.5
Interest 2.1 2.2
Profit before tax 6.8 8.3
Tax 3.5 4.1
Profit after tax 3.3 4.2
Dividends 2.7 2.7
Retained earnings 0.6 1.5
Per sharedata
Earning per share 2.2 2.8
Dividend per share 1.8 1.8
Market price per share 21.0 20.0
Book value per share 17.46 17.07
Source: Data adapted from P. Chandra 1993, Fundamentals of Financial Management, Tata
McGraw-Hili,New Delhi, India, p. 115.
City First Saddlery Limited

Statement of financial position as at 31 March ($'000)
LiabilitiesandEquity 2003 2002 Assets 2003 2002
Share capital 15 15 Net fixed assets 33 32.20

Gross assets 59
Reserves 11.20 10.60 Depreciation 26
Secured loans 14.30 13.10 Investments 1 1
Term loan 8.30
Debentures 6.00 Current assets 23.40 15.60
Cash 0.20
Unsecured loans 6.90 2.50 Debtors 11.80
Inventories 10.60
Current liabilities and 10.50 8.10 Prepaid expenses 0.80
provisions
Miscellaneous expenditure 0.50 0.50
and losses
57.90 49.30 57.90 49.30
Source: Data adapted from P.Chandra 1993, Fundamentals of Financial Management, Tata McGraw-Hili,New Delhi,
India, p. 115.
50 Part2: Analysisand interpretationof creditrisk

Liquidity ratios
Liquidity refers to the ability of a firm to meet its short-term obligations - that
is, whether the business is in a position to pay financial obligations that will
arise in, say, the next year. Liquidity is an important aspect to be watched in any
business. The failure of many businesses has been due to lack of adequate
liquidity. Liquidity can be described as the lubricant that helps the business run
smoothly: just as a car needs to have sufficient lubricating oil (engine oil,
breaking oil and so on), a business needs to have adequate liquidity at all times.
To check whether a firm has adequate liquidity, financial institutions compute
liquidity ratios. Two principal ratios that are commonly used to judge the
liquidity position of any business are:
• the current ratio
• the qUick ratio.
The current ratio
The current ratio is the ratio of current assets to current liabilities. Current
assets include cash, marketable securities, debtors, closing stock (ending inven-
tory), loans and prepaid expenses. Current liabilities are borrowings for the
short term, trade creditors, accrued expenses and provisions.
Formula
The current ratio is calculated by the following formula:
Current assets
Current liabilities·
For City Saddlery Ltd, the current ratio was:
2003 2002
23.4 = 1 34 lS.60 = 1.47.
17.4 . 10.60
The denominators 17.4 and 10.60 are arrived at by adding unsecured loans
and current liabilities and provisions - that is, 6.90 + 10.S0 and 2.S0 + 8.10
respectively.
Benchmark
Generally, the benchmark current ratio is 2. Clemens and Dyer (1986) have
recommended a ratio of 2 to 1. If the ratio is 1. S-2, then it is considered to be
satisfactory. If it falls below 1, then it is indicative of liqUidity problems. If it is
over 2, then it indicates excess liquidity. These benchmarks are just rules of
thumb and need not be given undue importance. Factors such as industry prac-
tice and past trends of the firm are more important and should be the deciding
factors over the rules of thumb. This is true for all types of ratio. What is the
assumption behind this benchmark of 2? The assumption is that even if the busi-
ness were shut down today and current assets sold at half price (fire sale), the
business would still have sufficient funds to pay current obligations. The current
ratio of 2 is like an insurance against short-term insolvency of the firm.
Interpretation
A ratio of 2 is regarded as ideal yet seldom does a business have the ratio
exactly at 2. The ratio could fluctuate between 1.5 and 2, which is not a con-
cern. A ratio that is too high or too low, however, should be a concern. A very
high ratio may arise due to one or more of the following reasons:
• A very high ratio indicates excess liquidity. The business may be losing
opportunities to make profitable use of current assets.
• The high ratio could also be because the party (borrower) is holding excessive
debtors or perhaps because debtors have not been collected. As a result, the
figure of current assets - that is, the nominator - will be very high, as will
be the ratio. Check for these possibilities: check, for example, the average
collection period or the debtor turnover ratio (discussed later). If these ratios
are not excessive - that is, the collection period is normal (according to
industry practice or the past trend of the party) - then we have nullified the
possibility that excessive current ratio is due to high trade debtors.
• The party might have sold some goods just before the date on which
financial statements were prepared, so the figure of trade debtors may be
high, raising the current ratio. In such cases, calculation should be based on
average debtors during the year. To find the average debtors, add the debtors
at the end of each month in the year and divide the resultant figure by
twelve.
• A high current ratio may arise due to excessive inventory build-up. For this
reason, the average inventory (calculated using the same procedure as
indicated earlier for debtors) level should be checked and used in the
calculation of current ratio.
• As in the case of debtors, the ending inventory figure may be excessive
because some goods were sold just after the date of the statement of financial
position. Check for such possibilities and use average figures rather than
year-end figures to arrive at the current ratio.
• Inventory valuation is another grey area. Overvaluing of the inventory can
artificially raise the figure of stock held and thus also the current ratio. The
party may change the basis of inventory valuation and thus obtain a higher
value for the same quantity of stock. The Australian Accounting Standards
Board recommends the use of the 'first in, first out' (FIFO) method for
inventory valuation, not 'last in, first out' (LIFO). You may come across these
concepts in your study of cost accounting. Overvaluation of stock will not
only raise the current ratio, but also will overstate profits.
A low current ratio is indicative of liquidity (working capital) shortage and is
a cause for concern. In sum, both low and high current ratios need to be
watched carefully.
The quick ratio
Another measure of liquidity is the qUick ratio, also called the acid test ratio. It
is much the same as the current ratio except that inventory is excluded from its
calculation.
52 Part2: Analysisandinterpretationof creditrisk I

The quick ratio is a ratio of quick assets to current liabilities. Quick assets
include all current assets except inventory (raw material, work in process and
finished goods).
Formula
The qUick ratio is calculated by the following formula:
Quick assets
Current liabilities'
For City First Saddlery Limited, the acid test ratio for 2003 and 2002 was:
2003 2002
12.8 = 0.74
17.4 = 0.66.
(Please note that the figure of inventory for 2002 is assumed at 8.60, so the
nominator will be 15.60 - 8.60 = 7.)
Benchmark and interpretation

The quick ratio is a fairly stringent measure of liquidity. It is based on those
current assets that are considered to be highly liquid. Inventories are excluded
from the numerator of this ratio because they are considered to be the least
liquid component of current assets. The rule of thumb for quick ratio is 1:
'many firms like it (acid test ratio) at 1:1 or better' (Argenti 1976, p. 139).
This means that quick assets should be equal to current liabilities. Selling of
inventory may be a difficult process and the lender wants to ensure the busi-
ness can meet current liabilities out of quick assets alone (current assets other
than inventory). If the ratio is unity (equal to 1), then the business can easily
meet the current liabilities out of its quick assets.
Efficiency ratios
We stated earlier that one of the characteristics of a financially sound busi-
ness is that it is run efficiently. To measure efficiency, financial analysts cal-
culate the efficiency ratios. The efficiency ratios measure how efficiently the
business has employed its assets. These ratios are based on the relationship
between the level of activity (represented by sales or the cost of goods sold)
and the levels of various assets. Efficiency ratios are also called turnover
ratios, activity ratios or asset management ratios. The important efficiency
ratios are:
• the inventory turnover ratio
• the average collection period.
The inventory turnover ratio

The inventory turnover ratio shows the efficiency of management of inven-
tory. The ratio of net sales to inventory is called the inventory turnover
ratio.
Formula
The inventory turnover ratio is calculated by the following formula:
Net sales
Inventory
For City First Saddlery Limited, the inventory turnover ratio was:
2003 2002
70.1 = 6.11
10.6 = 6.83.
(The inventory for 2002 has been assumed at 9.12.)
The number of days for which inventory is tied up can be calculated by the
following formula:
Days in year
Inventory turnover ratio
For our example, the days for which money was tied up in inventory in 2002
equalled 365 divided by 6.11, or 59 days. For 2003, the number of days
equalled 365 divided by 6.83, or 54 days.
Benchmark
There is no benchmark for this ratio because the type of inventory deter-
mines what the ratio should be. Where items are fast moving, the ratio could
be as high as 12; in other cases, it could be as low as 3 or 4. If the business is
producing and selling daily necessities (perishable goods) - say, wholemeal
bread - then the ratio will be very high. On the other hand, if the business
is producing and selling durable goods - say, refrigerators - then the move-
ment of inventory will not be that fast. A rule of thumb could be that the
ratio is equal to 4.
Interpretation
A high ratio would indicate that the inventory is fast moving and that the prod-
ucts of the business are in high demand. The higher the ratio, the better it is. It
means that the inventory management of the business is very efficient. Caution
needs to be exercised, however, in interpretation of the ratio. A higher ratio may
result in frequent stock-outs and a consequent loss of sale and customers.
While calculating inventory turnover ratio, note the following points:
• The ratio can easily be manipulated by a change to the basis of the inventory
valuation.
• Sales should always be gross sales minus sales returns - that is, net sales.
Instead of net sales being used as the nominator, the cost of goods sold is
sometimes taken as the nominator. This seems reasonable because both the
nominator and denominator are then at cost.

• The year-end inventory figure may be misleading, so the average inventory
figure needs to be taken as the denominator. The average inventory can be
calculated by taking the average of month-end inventory figures; for
example, add the figures of inventory at the end of each month Qanuary-
December) and divide the sum by twelve to arrive at the average inventory.
• The ratio should be compared with the ratio of competitor firms or the
average ratio for the industry.
The average collection period

This ratio shows the efficiency in collection of receivables. A business that is
efficient in debt collection will face fewer liquidity problems. The average col-
lection period is the ratio of receivables to average sales per day.
Formula
The average collection period is calculated by the following formula:
Receivables
Average sales per day·
For City First Saddlery Limited, the average collection period was:
2003 2002
11.80 _ 61 d 9.76 56 d
70.1 +- 365 - ays 62.3 +- 365 = ays.
(The figure of 9.76 for 2002 has been assumed.)

Benchmark
The average collection period should be equal to or less than the firm's credit
terms for its customers. If it is the policy of City First Saddlery Limited to
allow up to one month's credit only, then the ratio as above is unsatisfactory.
The firm's credit policy is usually determined according to the general market
practice. New firms generally allow a longer credit period to penetrate the
market. Similarly, firms may allow a longer credit period when introducing
new products.
Interpretation
If the average collection period calculated by the above formula is less than
the credit term generally allowed by the firm, then the debt collection of the
firm can be regarded as efficient. On the other hand, if it exceeds the credit
term, then the collection cannot be regarded as efficient. Note the following
points:
• The nominator should be average receivables instead of year-end receivables.
As in the case of inventory, the average receivables can be calculated by
averaging the month-end receivables.
• Similarly, average sales can be calculated by averaging the month-end sales
figures.
:I' -
• The average collection period ratio hides the age-wise distribution of
receivables, so it should always be read in conjunction with the summary
of age-wise (days collection in arrears) receivables. For this purpose, the
receivables can be classified into three categories:
receivables pending collection for more than three months
- receivables pending collection between one and three months
- receivables pending collection for less than one month.
If most of the receivables are in the last category, then there is no cause for
worry. If most of the receivables are in the first two categories, however, then
receivables management is slack. This situation may lead to liquidity problems.
Profitability ratios
A financially sound business is likely to be a profitable business. The two popular
profitability ratios are the gross profit-sales ratio and the net profit-sales ratio.
The gross profit-sales ratio
This is the ratio of gross profit to net sales, where gross profit is defined as the
difference between net sales and the cost of goods sold.
Fonnula
The gross profit-sales ratio is calculated by the following:
Gross profit
Net sales .
For City First Saddlery Limited, the ratio was:
2003 2002
14.9
70.1
= 0 .21 ,or 210/
/0
14.8 = 0.23, or 23%.
62.3
Benchmark
There is no benchmark for this ratio, but the ratio is expected to be at least
equal to the industry average or more.
Interpretation
The higher the ratio, the better it is. The ratio measures the pricing and pro-
duction cost control aspect. The firm may have less control over pricing,
because the market decides price, but it can control the costs. The ratio should
be compared with the ratio of other firms in the industry.
The net profit-sales ratio
This ratio captures the profitability of the firm when all the costs (including the
administrative costs) are considered.
Fonnula
The net profit-sales ratio is calculated by the following formula:
Net profit
Net sales'

2003 2002
= 0.047, or 4.7% = 0.067, or 6.7%.
The ratio can be calculated by taking either net profit after tax (as in the
above case) or net profit before tax as the nominator.
Benchmark
Again, there is no benchmark for this ratio. The ratio should be equal to or
more than the industry average.
Interpretation
The higher the ratio, the better it is. The ratio provides a valuable under-
standing of the cost-and-profit structure of the firm.
Leverage ratios
Financial leverage means the use of debt finance. Leverage ratios help us assess
the risk arising from the use of debt capital. It has been found that if a positive
financial leverage could be established, then debt capital is a preferred source of
finance. Analysis of financial leverage generally uses two types of ratio: struc-
tural ratios and coverage ratios. The structural ratios are the debt-equity ratio,
the proprietary ratio and the debt-assets ratio, while the coverage ratios are the
interest coverage ratio and the fixed charges coverage ratio.
The debt-equity ratio
This ratio shows the proportion of amount borrowed by the firm compared
with the proprietor's own investment in the business. It is a ratio of debt to the
equity of the firm. The debt consists of all liabilities of the firm, whether short
term or long term, and the equity consists of capital and reserves.
Formula
The debt-equity ratio is calculated by the following formula:
Debt
Equity
2003 2002
31.7 = 1 21 23.70 = 0 93
26.2 . 25.60 . .
Benchmark
Generally, the ratio should not exceed 2. This means that at least 33 cents in a
dollar should come from the firm's own funds. In some firms, the debt-equity
ratio could be much higher as a result of the nature of the business. Mining,
fertiliser, shipping and cement companies, for example, may have a much larger
ratio.
I' -
7
Interpretation
The lower the ratio, the better it is. A lower ratio, as in the case of City First
Saddlery Limited, indicates that creditors enjoy a higher degree of protection
because the proprietors' stake in the business is large. Note the following points:
• The book value of equity may be understated, where equity is shown at
historical (book) value in the statement of financial position yet the true
worth of the company is much higher.
• Some long-term debts, such as debentures, may already be secured by a
charge on assets of the firm.
• A lower debt-equity ratio is not necessarily a good sign. It may mean that the
firm is not making use of the leverage to its advantage.
• Two other ratios that give information similar to the debt-equity ratio are the
proprietary ratio and the debt-assets ratio. The former is the ratio of the
proprietor's funds to total assets, while the latter is the ratio of debt to total
assets. The debt-eqUity ratio is the ratio of these two ratios: that is, the ratio
of the proprietary ratio to the debt-assets ratio is equal to the debt-equity
ratio. The proprietary ratio indicates the stake of the proprietor in the
business. The higher the stake, the better it is. Australian banks generally
require a proprietary ratio of 40 per cent.
The interest coverage ratio
The interest coverage ratio is the ratio of earnings before interest and taxes on
debt interest. It shows whether the firm has sufficient resources to cover the
interest portion of the debt. In the case of a firm having financial difficulties, the
bank may postpone the repayment instalment but would insist on, at least, pay-
ment of the interest on the debt. If a firm is unable to pay even the interest,
then it is in serious financial difficulty.
Fonnula
The interest coverage ratio is calculated by the following formula:
Earnings before interest and taxes

Interest payable on loans
2003 2002
8.9 = 4.23 10.5 = 4.77.
2.1 2.2
Benchmark
There is no benchmark for this ratio, but the ratio should be at least 2 to give
the firm sufficient buffer to pay interest on the debt.
Interpretation
The higher the ratio, the better it is. Earnings before interest and taxes are
considered as the nominator because interest is usually paid before taxes.

Further, interest on the debt is a tax-deductible expense. Lenders commonly
use this ratio. Note, however, that payment of interest comes from cashflow
and not from earnings, so the lender must carefully examine the cash flow
statement in addition to this ratio. This ratio is sometimes calculated by
adding depreciation to the nominator.
The fixed charges coverage ratio
This ratio is the ratio of earnings before interest and taxes plus depreciation to
interest on the loan and the loan repayment instalment. It is used to measure
the debt servicing capacity of the firm.
Formula
The fixed charges coverage ratio is calculated by the following formula:
Earnings before interest and taxes + Depreciation
Interest on loan + [Repayment of loan + (l - Tax rate)] .
For City First Saddlery Ltd, the ratio was:
2003 2002
11.9 =3.27 13.5 = 3.52.
2.1 + 1.0 + 0.65 2.2 + 1.0 + 0.65
(Depreciation has been assumed at 3.0 for 2002, and the repayment instalment
has been assumed at 1.0 for both years. The tax rate has been assumed at 35 per
cent.)
Please note that only the repayment of the loan is adjusted upwards for the
tax factor, because the loan repayment amount (unlike interest) is not tax
deductible.
Benchmark
There is no benchmark for this ratio. The higher the ratio, the better it is.
Interpretation
The ratio measures the debt servicing ability because, besides interest on the
loan, it also includes the repayment instalment. This ratio is particularly impor-
tant in project financing.
Here ends our discussion of ratio analysis. We will now turn to the other
cross-sectional technique: common-size statements.
Common-size
statements
Common-size analysis came into vogue because interfirm comparisons were
needed. When firms are of different sizes, it is hard to compare them unless
their financial statements are expressed in a common form. This common form
is created by expressing the components of the statement of financial position
and statement of financial performance as a percentage of total assets and total
revenue respectively. Table 2.1 (page 60) illustrates a common-size statement of
financial position.
TABLE 2.1 A format of a common-size statement
Percenlages10lolaIassels (%)
FirmA FirmB FirmC Firm0
Accounts receivable 7.6 9.8 3.2 5.4
Inventories 20.5 23.7 35.2 48.1
Accounts payable 15.9 5.6 6.7 19.2
Equity 36.2 21.5 65.4 49.2
Table 2.1 covers only items on the statement of financial posmon; it can
similarly be prepared for all items, expressing them as percentages of total
assets. Several inferences can be drawn from the data in table 2.1. Firm C has a
very high equity-total assets ratio compared with that of other firms, while firm
B has the lowest. Firm D has a very high proportion of inventories (possibly
due to slow-moving stocks) compared with that of other firms. Other useful
inferences can be drawn too. In this way, the statement indicates the directions
in which further analysis needs to focus.
Timeseriestechniques
Time series analysis involves analysing financial information such as ratios
over a period of time. According to Foster (1986), it involves the following
techniques:
• trend (indexed) statements
• the trend of financial ratios
• variability measures.
Each of the above will be discussed in the following paragraphs.
Trendstatements
Constructing a trend statement involves expressing the items in a financial
statement in an indexed form. This means choosing one year as the base, then
expressing the values of an item for subsequent years relative to their value in
the base year. The sales revenue of City First Saddlery Ltd during 1999-2003,
for example, could be expressed in indexed form as shown in table 2.2.
TABLE 2.2 Indexed statement of sales revenue
1999 2000 2001 2002 2003
Sales revenue 56.7 58.4 60.2 62.3 70.1
Indexed sales revenue 100.00 103.00 106.17 109.52 123.98
Such indexed statements are prepared for all the items of the statement of finan-
cial performance and the statement of financial position. The sales revenue can
then be factored into its price and quantity components. According to Foster
(1986, p. 71), this can be 'especially insightful in industries where marked
changes in price or quantity can occur over relatively short time periods'.
60 Pari2: Analysis and interpretation of credit risk

Thetrendoffinancialratios
Analysis of time series trends in financial ratios is another useful technique.
This involves computing financial ratios (those we discussed earlier) for a series
of years for the same firm, and studying their trend. For City First Saddlery
Limited, a statement of trend of financial ratios could look as in table 2.3.
TABLE 2.3 Statement of the trend of financial ratios
1999 2000 2001 2002 2003
Current ratio 1.12 1.19 1.28 1.47 1.34
Debt-assets ratio 0.52 0.61 0.59 0.93 0.55
Inventory turnover ratio 5.52 5.78 6.15 6.83 6.61
Average collection period (days) 55 59 65 56 61
Note: Figures for 2002 and 2003 are as computed above; figures for 1999-2001 have been assumed.
The cross-sectional financial ratios are helpful but may not be adequate. They
are likely to be influenced by transitory forces and fail to show the secular
trend. A study of ratios over a period of time provides additional insights. A
sharp rise and decline in the debt-asset ratio during 2001-03, for example,
should arouse an analyst's interest.
Variabilitymeasures
What is not discerned by observing a trend can be known by computing a
measure of variability of the ratio. According to Foster (1986), such variability
in a single ratio can be computed as follows:
Maximum value - Minimum value

Mean financial ratio
If the net profit-sales ratio of a firm for a series of years is available, then the
above values can be fitted in and the variability can be computed. A higher vari-
ability shows the firm's riskiness with respect to that financial ratio.
Combiningfinancialstatement
andnonfinancial
statement
information
Other than financial statements, some nonfinancial information about the
product and the capital markets can be factored into the analysis. Data about
the shift in the market share of firms within an industry, for example, will show
how the firm being analysed is performing. Similarly, by 'examining changes
over time in market capitalisation (market price per equity share multiplied by
number of common shares outstanding), insight can be gained about changes
in the consensus expectation of the relationship between future and current
profitability' (Foster 1986, p. 74).
In this section, we have outlined several techniques for analysing financial
statements. Such a detailed financial statements analysis may be required only
•• "., 4:
fiR
in the case of large corporate entities such as BHP Billiton. Where the firm is a
small or medium-sized sole proprietorship or partnership, financial ratio
analysis with the trend for, say, the previous three years could be sufficient. The
rigour with which a lender performs financial statements analysis also depends
on the quantum of finance involved.
There are occasions when the financial requirements of a business are so
large that a financial institution may consider it too risky to finance these
requirements on its own. In such a case, the lender can form a consortium with
one or two other lenders to meet the financial requirements of the borrower.
Such arrangements are called consortium finance or syndicated loans. Risk may
not be the only reason that financial institutions enter into such arrangements.
Legal barriers also may prevent a bank from meeting the entire financial
requirements. Exposure regulations, for example, prescribe that a bank should
not give loans in excess of 30 per cent of its issued capital to a Single borrower.
Banks sometimes do not issue loans, but instead contribute capital to the busi-
ness, becoming a part owner of the business through what is called equity
participation. Syndicated loans and equity participation often involve a large
quantum of finance and may be for a long period of time (say, ten years or
more). Equity participation may be for life of the company. Given the nature of
the finance and the period involved, such finance is generally classified as pro-
ject finance. Project finance is given to carry out a distinct activity, such as
starting a new product line. In some countries, special banks have been estab-
lished to handle project finance. Term lending institutions such as the Asian
Development Bank, the Industrial Bank of Japan, the Industrial Development
Bank of India and the former Commonwealth Development Bank in Australia
use a different set of techniques to evaluate applications for project finance.
Project evaluation requires additional techniques, because the traditional
financial statements analysis may not be helpful. Such analysis is based on
financial statements that belong to the period that has already elapsed. At the
most, these statements give an idea about the management of the firm; that is, if
the firm is running its existing business successfully, then one can assume that
it will be successful in its new venture. Given that the new venture is distinct
from the existing line of business, we need a separate set of financial statements
and special techniques for evaluation. Normally, banks (or term lending insti-
tutions) obtain a project report that includes the projected financial statements.
The projected financial statements are also analysed by the various techniques
discussed earlier. In addition, special techniques are used to evaluate the pro-
ject. You may have already encountered these techniques in your study of busi-
ness finance. The firm will use the following techniques to evaluate the project
and then present the results in the project report. A lender needs to be familiar
with these techniques because he/she may be required to check the correctness
of the facts presented by the firm. We will give a brief overview of the
techniques used to evaluate applications for project finance; more details can be
found in any standard text on business finance.
62 Part2: Analysisandinterpretationof creditrisk

Techniques
ofanalysisusedin projectfinance
The commonly used project evaluation methods are:
• the payback period
• the accounting rate of return
• discounted cashflow techniques such as the net present value, the internal
rate of return and the benefit-cost ratio.
Thepayback
period
The payback period is the time it takes for an entity to recover a project's initial
cash outlay (Peirson et al. 1998, p. 176). If an initial outlay on the project is,
say, $50000 and the net cashflow in the first four years is $10000, $11 000,
$14000 and $15000, then the outlay will be recovered in four years and thus
the payback period is four years. If another project has net cash inflow of
$20000, $30000, $35000, $40000, then the payback period for this project is
two years. If there are more projects, then the lender prefers the project that has
a shorter payback period.
Theaccounting
rateofreturn
According to Peirson et al. (1998, p. 176), 'the accounting rate of return is the
earnings from a project, usually after deducting both depreciation and income
tax, expressed as a percentage of the investment outlay'. Imagine a project has a
life of, say, five years with an annual return (after depreciation and taxes) of
$500, $750, $1000, $1250 and $1500 respectively, and the outlay is $10000.
The accounting rate of return is calculated by summing the annual returns and
dividing the sum by the initial outlay. In this example, it is equal to 50 per cent
($5000 divided by $10000). Other methods of computing the accounting rate
of return can be found in any business finance text.
Discounted
cashflow
techniques
There are three discounted cashflow techniques: the net present value (often
abbreviated as NPV), the internal rate of return (often abbreviated as IRR) and
the benefit-cost ratio (also called the profitability index).
Thenetpresentvalue
To compute the net present value, deduct the present value of net cashflows
from the initial outlay. The following formula is used:
where
Co = the initial cash outlay
C t = the net cashflow generated by the project at time t
n = the life of the project
h = the required rate of return.
/' -
For a project with a discount rate of 10 per cent, where the initial outlay and
subsequent cashflows are as given in the second column of table 2.4, the net
present value is calculated as shown in table 2.4.
TABLE 2.4 Calculation of the net present value
Discount
factorat
Year Netcashflows
($) 10percent Presentvalue($)
0 -3000.00
1 500 0.909 454.50
2 750 0.826 619.50
3 1000 0.751 751.00
4 1250 0.683 853.75
5 1500 0.620 930.00
Net present value = 608.86
The discount rate (required rate of return) is predetermined and generally

equals the interest rate on Treasury bonds plus the rate of inflation.
Theinternalrateofreturn
'Internal rate of return for a project is the rate of return which equates the
present value of the project's net cashflows with its initial cash outlay'
(Peirson et aL 1998, p. 163). The formula used for calculating the internal
rate of return is the same as that for calculating the net present value,
except that it is equated to 0 and k is replaced by r. The r gives the
internal rate of return, which is then compared with k or the expected rate
of return. I f r is greater than k, then the project is accepted. The following
formula is used:
Ct
£... ---t - Co = O.
t=l (l+r)
The above can be restated as:
The internal rate of return is computed by trial and error, as shown in the
following example in table 2.5.

TABLE 2.5 Calculation of the internal rate of return
Discounted
at17percent Discounted
at18 percent
PVfactor PV PVfactor PV
Time Cashflow @ 17 percent @ 17 percent @ 18percent @ 18 percent
0 (600000) 1.000 (600000) l.000 (600000)
1 240000 0.855 205200 0.847 203280
2 210000 0.731 153510 0.718 150780
3 180000 0.624 112320 0.609 109620
4 250000 0.534 133500 0.516 129000
Net present value = 4 530 (7320)
The internal rate of return therefore lies between 17 per cent and 18 per cent.
Linear interpolation gives an approximation of the rate. As the discount rate
increases from 17 per cent to 18 per cent, the net present value falls by $11 850
($4530 plus $7320). The approximate internal rate of return can be calculated
using the following formula:
Net present value Difference between

at lower discount rate
Lower discount rate + ---: -::: ----------:,----- X higher and lower
Fall in net present value discount rates.
due to higher discount rate
In the above example, therefore:
Approximate internal rate of return = 17% + x 1%
= 17% + 0.38%
= 17.38%.
Benefit-cost
ratio
The benefit-cost ratio is a ratio of the present worth of benefits and the present
worth of costs. To calculate this ratio for our example, add up all the positive
values from the last column of table 2.4 (the present worth of benefits) and
divide the sum by all the negative values (the present worth of costs). The
benefit-cost ratio is used almost excluSively as a measure of social benefit, that
is, for economic analysis... It is almost never used for private investment
analysis' (Price Gittinger 1976, p. 60).
Projectriskanalysis
The above evaluation methods are only estimates that rely on the projected
financial statements (forecasted cashflow). In practice, these forecasts may turn
out to be incorrect. The operating costs may be higher than expected or the
sales revenue may be lower. Managers and lenders need to know the risks of
project forecasts going wrong. Project risk analysis commonly uses sensitivity
analysis, break-even analysis and simulation.
Sensitivity
analysis
'Sensitivity analysis involves assessing the effects of changes or errors in the
estimated variables on the net present value of a project' (Peirson et al. 1998,
p. 212). Sensitivity analysis is like stress testing: it helps answer questions such
as what the effect on the net present value will be if the net cashflow declines
by, say, 10 per cent. The two major types of sensitivity analysis are:
1. to compare the optimistic, pessimistic and most likely predictions
2. to determine the amount of deviation from expected values before a decision
is changed.
In the first case, the net cashflows under three situations (optimistic, pessi-
mistic and most likely) are estimated and the net present value is calculated
under each scenario. The results show the band in which the net present value
is likely to move. In the second case, a manager would reject a project if the net
present value drops below break-even.
Horngren and Sundem (1994, p. 383) state that 'sensitivity analysis pro-
vides an immediate financial measure of the consequences of possible errors
in forecasting' and thus helps in identifying decisions that prediction errors
may affect. Managers and lenders can then gather additional information to
arrive at the correct cashflows.
Break-even
analysis
Break-even analysis is a concept from cost accounting. It is a useful concept, not
only for the firm but also for the lender who is trying to assess the performance
and prospects of the firm. It is therefore discussed here in detail. Break-even
analysis involves calculation of the break-even point and the margin of safety.
'The break-even point is the level of sales at which revenue equals expenses
and net income is zero' (Horngren &. Sundem 1994, p. 38). It is a point that
indicates a 'no profit, no loss' position. Beyond this point, the firm starts
earning profits. The break-even point is often expressed in a number of units
and/or in dollar sales. It shows the number of units that must be produced or
sold, to achieve a 'no profit, no loss' position. I f the firm produces and sells
more units, then it will make a profit. Multiplying the number of units by the
sales price per unit gives the break-even point in dollar sales.
For calculating the break-even point of any firm, it is necessary to have infor-
mation about the fixed and variable costs of producing the units. Variable costs
are costs that vary directly in proportion to the number of units produced. If
100 units of a certain product are produced and the variable cost per unit is $4,
then the total variable cost is $400. I f the production is raised to 200 units, then
the variable cost is $800. As the units produced are doubled, the total variable
cost also doubles. It is important to note that the variable cost per unit ($4)
remains the same. The costs of raw materials, wages, power, fuel and so on are
examples of variable cost. I f you drive 10 kilometres and you require 1 litre of
petrol (which costs 86 cents per litre), then if you drive 50 kilometres you will
require 5 litres of petrol and your total fuel cost will equal 0.86 multiplied by 5,
or $4.30. The cost per litre remains the same at 86 cents.

Fixed costs are costs that remain constant whatever output is produced. Rent
is a typical example of a fixed cost. If a firm rents a factory shed and pays $300
as weekly rent, then it continues to pay the rent of $300 per week regardless of
whether it produces 600 units or 1200 units. If the firm produces more units,
then the fixed cost per unit declines. If 600 units are produced, then the loading
of rent cost per unit is 50 cents ($300 divided by 600); if 1200 units are produced,
then the loading of rent cost per unit is 25 cents ($300 divided by 1200).
The calculation of the break-even point requires information on fixed costs,
variable costs, sales revenue and units produced.
Illustration A
The total cost of producing 10000 units (say, bottles of coke) is estimated at
$20000, of which 60 per cent is variable and the remainder is fixed. If a coke
bottle is sold at $1.70, then calculate the break-even point.
Solution
Total cost = $20000
Variable cost = $12 000 (60 per cent of $20000)
Fixed cost = $8000 (Total cost $20000 - Variable cost $12 000)
Variable cost per unit = $1.20 (Variable cost $12 000 + 10 000)
Contribution (to fixed cost) per unit = $0.50 (Selling price $1.70-
Variable cost $1.20)
Break-even in volume of output = 16000 units (Fixed cost $8000 +
Contribution $0.50)
The firm must produce and sell 16000 bottles of coke to break even. At this
level of output, the revenue earned will fully cover the total costs of the firm.
Illustration B
If the firm produces 15000 bottles of coke, then will it make a profit or a loss?
Using the figures in the above example, let us work it out.
Solution
Fixed cost = $8000
Variable cost = 15000 x $1.20 = $18000
Total cost = Fixed cost + Variable cost = $8000 + $18000 = $26000
Total revenue = $15000 x $1.70 = $25500
Loss = $26000 - $25500 = $500.
If the firm produces less than the break-even output, then it will incur a loss.
On the other hand, if the firm produces more - say, 20 000 bottles of coke -
then it will make a profit. Once we know the break-even point, we can readily
know whether the firm will make a profit or a loss by producing a certain
volume of output.
Let us assume that the firm cannot raise production of coke bottles beyond
15000. What will the firm need to do to make a profit? The firm has two options:
cut costs or increase revenue. The firm can cut either variable or fixed costs, or
both. It will be hard to cut variable costs. We saw earlier that these costs vary
directly with the output. Many of the inputs are bought from the market and the
firm has no control over the price. Given the difficulties in slashing variable costs,
the firm is left with the alternative of cutting fixed costs. This may be possible.
If the firm rents a smaller factory shed, then it could reduce the rent cost (a fixed
cost). Alternatively, the firm could cut jobs and save the administration (say,
salary) cost. A third alternative is to raise the price of a bottle of coke to, say,
$1.80. The consumers may not be prepared to pay this price, however, and may
shift to other brands of cold drinks, which would reduce the volume of coke
bottles sold. The firm, therefore, has four choices. These choices are not mutually
exclusive and more than one can be used at the same time.
1. Cut variable costs.
2. Cut fixed costs.
3. Increase the sale price of coke bottles.
4. Produce and sell more bottles of coke than the break-even level of 16000
bottles.
The circumstances of every firm are different and the solution depends on
those circumstances. Why should the lender worry about these matters? The
reason is that it would be unwise for the financial institution to approve the
loan if the firm cannot be profitably run. The lender should always put himself!
herself in the shoes of the proprietor of the firm and ask whether the firm can
make a profit. The break-even analysis is a handy tool in this decision.
Margin of safety
One direct use of break-even analysis is for assessing possible business risk. The
concept of 'margin of safety' helps to assess the possible risk that the firm is
likely to face. It refers to the excess of actual sales over the break-even sales. If
the actual sales are $100 000 and break-even sales are $70 000, then the firm
enjoys a margin of safety of $30000. The margin of safety can be expressed as a
percentage of sales. Here, the margin of safety is 30 per cent ($30000 divided
by $100000). Margin of safety can also be expressed in terms of the volume of
production. If the break-even volume is 20000 units and the firm is prodUcing
and selling 30000 units, then the margin of safety is 10 000 units. Margin of
safety is like a buffer; if it is high, then the business is sound and has a comfort-
able cushion to absorb any shocks. A lender would be interested in knowing
the margin of safety that is available to the firm. If the margin of safety is large,
then the risk in lending is less.
Cash break-even point
A lender's preliminary concern is the repayment of the loan, so he/she is more
interested in the firm's cash break-even point than the simple break-even point.
The formula for calculating the cash break-even point is similar to the formula
that we used to calculate the earlier break-even point. Some adjustments, how-
ever, are reqUired, so the formula is:
Fixed costs + Loan instalment together with interest - Depreciation

Contribution per unit
I 68 Part2: Analysisandinterpretationof creditrisk

If the firm has already included the loan instalment together with interest in
the fixed costs while calculating the break-even point, then it need not add that
component again. If it has not, then it needs to add that component while cal-
culating the cash break-even point. Depreciation is a book entry and no pay-
ment is involved. If depreciation is not already deducted from fixed costs in the
calculation of the break-even point, then it needs to be deducted in the calcu-
lation of the cash break-even point.
The cash break-even volume of output must be produced and sold if the firm
has to service the bank loan together with interest. In the case of a new firm,
which has not yet started production, the lender has to find out how long the
firm will take to achieve the cash break-even point. The repayment instalment
will have to commence from that year.
Simulation
In sensitivity analysis, we change one variable at a time; in simulation, we con-
sider the effect of changing all the variables with uncertain values. Computers
make the task of simulation easy, allowing different scenarios to be constructed.
Simulation is a valuable tool that allows managers to analyse many aspects of a
project's risks.
Despite their knowledge and skill, novice analysts often find that financial state-
ments analysis in real world situations can be a daunting task. Some businesses
rarely keep systematic records and may not have adequate data available for
analysis; other businesses, such as large corporations, have too much data and the
analyst may find it hard to discern the essentials. When presented with financial
statements, novice analysts may not know where to begin and what to look for
in the bulk of information. In the following section, we will provide a step-by-step
approach to help such novice analysts or newly recruited bank officers.
Step-by-step
approach
tofinancialstatements
analysis
Financial statements analysis involves the following seven steps.
Step1: obtainrelevantfinancialstatements
The first step is to obtain financial statements from the applicant (the prospective
borrower). Three key statements must be obtained: the statement of financial
performance, the statement of financial position and the cash flow statement. In
the case of borrowers that are public companies, obtain the directors' and audi-
tors' reports too. How many years of financial statements should be obtained?
The general practice is to obtain statements for a period of three years - that
is, the latest year and the immediate previous two years. Why not five or seven
years? As a lender, you are concerned about the business's performance in recent
years rather than in the distant past. If the borrower closes accounts inJune every
year and approaches for a loan in September 2003, then you require the financial
statements for the years ending June 2003,June 2002 and June 2001. If, however,
the borrower approaches in May 2003, then you should ask for the financial state-
ments up to March or April 2003 and for the years ending June 2002 and June
2001. You may also obtain projected financial statements for the term of the loan.
Thus, if the term of the loan is five years, then obtain the projected cashflow
statement for five years.
Step2: checkforconsistency
Ensure the business name and address on the financial statements are exactly the
same as indicated in the loan application form. If ABC Brothers are applying for
a loan, then the financial statements should be in the name of ABC Brothers, not
ABC Sons or ABC Ltd. Remember, the loan is being approved on the strength of
financial statements, so these must be of the same firm that is applying for the
loan and not of a related concern. Preferably, all the pages of financial statements
should be affixed with the firm's seal and signed by the authorised person or
borrower. The financial statements of a partnership, for example, must be signed
by one of the partners - even better, by all the partners - and bear the seal of
the firm. In the case of companies, the authorised directors should sign and seal
the financial statements. If false information is submitted, then the entire loan
can be recalled and the borrower can be sued. If the accounts have been audited,
then the statements should be certified (signed and sealed) by the auditors.
Otherwise, a lender may insist, as an additional precaution, that the auditors duly
certify the statements.
Step3: undertake
preliminary
scrutiny
Examine the statement of financial position.
• Check the arithmetic accuracy of the statement of financial position. Are the
totals correct? If not, seek clarification from the party. Ensure arithmetical
accuracy at the beginning; otherwise, after elaborate calculations of ratios,
some arithmetical inaccuracy in the statements may come to light.
• Take a note of the sources and uses of the funds of the business. In particular,
take a note of the parties from whom the business has borrowed money. Take
a note of the top three sources and uses of funds. This gives you a general
idea about the sources and uses of funds.
• What is the amount of owned funds? What is the amount of borrowed funds?
What is the approximate proportion that is borrowed?
• Is the amount of ending inventory shown on the credit side of the statement
of financial performance the same as that on the asset side? Ask whether
there is any difference.
• Is the profit shown in the statement of financial performance carried over to
the statement of financial position? Check that the amount is the same.
• Are there any abnormal items? Are any items unusually large or unusually
small? If so, what are they? Why are they larger or smaller than reasonably
expected?

• Check the amount of debtors compared with sales. Approximately how many
days of sales are tied up in debtors? If the business is offering longer credit
than is the general practice, then be cautious; ask the borrower for reasons.
• Check the amount of trade creditors compared with the amount of purchases
made. Is the proportion too high compared with the usual business practice?
Ask the borrower how many days of credit are normally available from
suppliers. Cross-check that number with what you have calculated. Is it
greater? If so, why? Seek answers from the party.
Examine the statement of financial performance.
• What is the bottom line? Is the business running in profit?
• What is the quantum of profit compared with the sales volume?
• If the statement of financial performance is available for three years, are sales
rising? Are profits increasing?
• What are the three major items of income and the three major items of
expenditure?
• Check the arithmetic accuracy of the statement of financial performance. Are
the totals correct? If not, seek an explanation from the borrower.
• Are any items unusually large or unusually small? If so, what are they? Why
are they larger or smaller than generally expected?
• Are profits calculated after providing for depreciation? If not, why not? The
party may be showing artificially higher profit without providing for normal
depreciation.
Examine the cashflow statement.
• What are the major sources of cash generation?
• What are the major sources of cash outflow?
• How reliable are these sources? Are they sources from which regular cash
inflows are expected or one-off sources?
• Which are the months in which surplus cash is available?
• Which are the months in which there is generally a cash deficit?
The purpose of asking the above questions is Simple. Even with only a prelimi-
nary examination of financial statements, a lender can obtain a reasonably good
idea of the financial condition and performance of the business. More detailed
analysis, such as ratio analysis, will also provide similar information. Such a
sophisticated analysis has more to do with confirming the initial opinion
formed about the business from the financial statements.
Step4: collectdataaboutindustry
andgeneraleconomic
trends
Collect information about the industry trends, general economic trends and
financial information of similar firms. Industry trends and ratios for various
firms within the industry are available from the respective industry associations.
Information could also be available from financial newspapers, professional
journals or specialist firms such as Dun & Bradstreet. A study of this type of
information helps to get an overall picture about the industry within which the
firm is operating. Please remember that 'a firm' means a single business entity
while 'industry' means a group of similar firms. Qantas and Virgin Blue are two
of the firms in the airline industry, for example.
Step5: conduct
a comparison
withindustry
averages
Work out the ratios for each of the years for which you have the financial state-
ments of the firm, and indicate the industry averages against each of the ratios.
Your statement of financial analysis could appear as in table 2.6.
TABLE 2.6 Comparison of financial ratios with industry averages
CompanyA Industry CompanyA Industry CompanyA Industry

Typeof ratio 2001 2001 2002 2002 2003 2003
Current ratio 1.23 1.61 1.33 1.71 1.12 1.30
QUick ratio 0.67 0.98 0.62 0.92 0.72 0.95
Prepare a statement as in table 2.6 for all the financial ratios. Such a state-
ment shows, at a glance, how the ratios of the firm are moving from year to
year and how they compare with the industry averages. The central credit
department of a bank generally collects information about industry ratios and
circulates it to all branches. Similarly, the economic intelligence department
of a bank conveys comments about economic trends and industry trends,
usually through a monthly commentary. You can also obtain the information
from financial newspapers such as the Australian Financial Review or the
'Business' supplement of the Australian. Other sources include the Bulletin of
the Reserve Bank of Australia, the Economic Round Up of the Commonwealth
Treasury, the Australian Prudential Regulation Authority and the web sites of
these organisations.
Step6: dosupplementary
analysis
At this stage, conduct supplementary analysis such as break-even analysis and
sensitivity analysis. The purpose is to validate the conclusions from step 5. If
financial statements analysis shows profitable operations but the firm is oper-
ating at below the break-even point, this should raise doubts. You will need to
do further probing. Similarly, sensitivity analysis will show the shock-absorbing
capacity of the firm. Shocks may come from economic downturns. If a
recession in the economy means the demand for goods produced by a firm
declines by 10 per cent, for example, will the operations of the firm remain
profitable? As repeatedly stated, financial analysis is merely a tool in the hands
of the lender. The lender has to make a decision by considering other factors
and using judgement.
Step7: summarise
themainfeatures
Prepare a summary of the firm's main features as revealed by the analysis of
financial statements in steps 3-6. This is a skilled job and insights can come
I 72 Part 2: Analysisand interpretationof credit risk I

with experience. You will rarely find that all the ratios are favourable or
unfavourable; generally, some ratios and trends will be favourable while some
will not. Some unfavourable features do not mean that you should immediately
reject the loan application. You may still approve the loan, but include a con-
dition that the firm must strive to correct the unfavourable features. If the
debtor turnover ratio is not satisfactory (that is, it is taking too long to collect
the debts), then the bank may approve the loan subject to the condition that
the firm tighten the debt collection procedure (possibly by more frequent moni-
toring) and bring the ratio within an acceptable range.
Ratios do not tell the full story, but 'torture' them and they will confess. A
current ratio of 2 for a certain firm may sound good, but suppose the current
assets are high due to unsaleable inventory: is the ratio of 2 any good? A prudent
analyst must probe further and satisfy that the ratio means what it is conveying.
This requires careful investigation of the composition of a ratio's nominator and
denominator. Financial statements analysis is not a static process of mechanically
drawing conclusions. It is a dynamic process, where opinions formed from a cer-
tain ratio need to be rechecked and probed by other means.
If ratios are like criminals that we would like to confess, then we can apply
three basic principles called the ABC of criminology: accept nothing, believe
no-one and confirm everything. These principles may also be useful for the entire
credit assessment process. Credit assessment is not, however, a criminal investi-
gation. The point to learn is to not accept everything at its face value. If the finan-
cial statements of WorldCom were analysed with the above principles in mind,
then perhaps irregularities would have been noticed much earlier. By constant
questioning and probing, a lender can detect frauds, errors or any window
dressing by a firm. In the following section, we will discuss these problems.
Detecting
windowdressing,
fraudsanderrors
The collapse of the insurance giant HIH shocked Australians. Even though the
company had a professional management, had its accounts audited by a reputed
accounting firm and was under the regulatory eye of both the Australian Secu-
rities and Investments Commission and the Australian Prudential Regulation
Authority, HIH probably resorted to 'creative accounting'. The financial state-
ments were made up and did not give a true and fair view. The provisional
liqUidator for HIH, Mr Tony McGrath, stated that 'I think it is fair to say that
the accounts that were prepared were prepared at the aggressive end of the
equation. As to how creative they were I think it is far too early for me to offer
any views on that' (Pascoe 2001a, p. 1).
How can a financial institution guard itself if a firm resorts to creative
accounting? There are several ways in which a lender can detect window dressing,
as listed on pages 74-6. One advantage for the financial institution is that it need
not rely on only publicly available information; it has every right to seek any
further details from the firm as it deems fit. If a firm avoids giving details, then
the financial institution should be more circumspect in advancing the loan.
1. Check the details of receivables. Are there any receivables in arrears for more
than sixty or ninety days? If so, then exclude these old receivables from the
calculation of the working capital requirements and the current ratio. Further,
of the receivables in arrears for less than sixty days (called 'eligible debts'),
banks will finance up to 75-80 per cent of the value. The bank may obtain a
list of debtors and decide which receivables are to be included in the 'eligible
debts'. Some debtors may be customers of the bank, so the bank may already
know their credit history. It is also necessary to ensure receivables are not
concentrated with a few parties. This is because the firm may be in serious
trouble if these debtors go bankrupt. Coastales and Szurovy (1994) state that
a firm may sometimes issue 'fake' invoices (to raise the figure of receivables)
and include these in a statement of receivables submitted to the bank. If the
lending officer is too busy and accepts the statement furni5hed by a firm
without questioning, the advance will be made against the fake receivables
too. The firm has thus drawn cash against 'ghost' debtors. The auditors cannot
catch this problem because they will give the firm a clean bill of health based
on documents in the file. The fake invoices are paid out of issuing other fake
invoices. Sometimes, the firm may not issue completely fake invoices, but
instead resort to overinvoicing existing parties. This practice helps raise the
sales figure and thus the profit. Watch whether receivables are genuine, due
and enforceable. Any portion of receivables from related parties is better
excluded if it does not represent bonafide receivables.
2. Check the valuation of inventory. Call for the break-up of inventory - that
is, raw material, works in process and finished goods. Raw material and
finished goods are generally valued at cost price or market value, whichever
is less. The Australian Accounting Standards Board requires inventory to be
valued using the FIFO method. The valuation of works in process is harder.
Such inventory is generally valued at cost. Banks are prepared to give more
advances against raw material (up to 80 per cent), which can be easily sold.
If the finished goods have a good demand, then an advance may be made to
the extent of 80 per cent. Only about a 50 per cent advance will be given
against works in process, however, because it is hard to sell unfinished
goods. Check the inventory turnover ratio. Is the inventory fast moving? If
not, be more circumspect in your decisions.
3. Check the machinery valuation. Machinery and equipment need to be
valued with care and at cost or market price, whichever is lower. It is poss-
ible that the equipment may have become obsolete
4. Check the real estate valuation. Real estate may be worth much more or
much less than the value appearing in the statement of financial position.
Real estate should be valued at a price at which comparable property was
sold in recent times.
5. Check the valuation of marketable securities. Securities should be valued at
cost or market price, whichever is lower. Any marketable securities of
long-term nature should be excluded from current assets.
6. Check for other 'creative accounting' techniques, as listed in figure 2. I.

1. Delaypublishingthe resultsfor as long as possible.Thereare limits to thiS.legal onesinmost
nations,but it is rare n0110be able to get away with a delay of at least one and perhapstwo
years. This is often enough; beyond that either the companyhas failed or it has recovered..
Delayedaccounts,then, are a useful symptomfor outsideobserversto watch for. .
2. Capitaliseresearchcosts,eitheron the basisthatthesewill be writtenoff againstordersalready
receivedor againstordersexpectedto be received. .
3. Continuepaying dividendseven if you have to raise equity or loanst() do so. (While this may
put shareholdersoff the scent, it may not confuseinvestmentsanalysts.)
4. Cut expenditureon routinemaintenanceuntil the plant is in such a poor state of repair that a
major renovationis needed.ThiScan be treated as capital.
5. In many nations..leasingand hire purchasearrangementsdo not have to be shown as loans
in companyaccounts.Althoughthey are usualJya very expensivesource of capital, their use
does reduce apparentgearing.
6. Instructall accountsdepartmentsto treatextraordinaryincomeas ordinaryandordinary
diture as extraordinaryas far as possible.This of course improvescurrent profits.
7. Instructat! subsidiariesto increasetheir dividendsto the parentcompany.(If you have no subi-
s/diaries,you had better get some if you want to use this and number 8.) .
8. Year by year bring into your consolidatedaccountsprogressivelymore and moreresutts, first
from your 100 per cent owned subsidiaries,then 75 per cent, then 50 per cent.
9. Proprietorsof small businessesshould retainthe company'smain asset in their name or that
of their wife. If the companyfails, most of the debts will then have to be met.by the creditors.·
OutSideobservers- especiallycreditors- shouldcheckthis point for any suspectcompany.
10. Valueyour assetsat Whateverfigure suitsyou. Eitherthe auditorswill not noticeor, if you elect
one of their partnersto the board, they will say nothing.
.11. It is not only researchcosts that can be capitalised;so can trainingcosts, interestchargeson
loans, the costs of setting up a computer,advancepayments.
12. Inflationhas seriouslyupset many accountingconventions.It sflould be possible to use it as
a smokescreenin revaluingassets,for example.
13. Certainof a company'sdebtscan be met out of the proprietor'sownpocket.(Thisis especially
useful to improveapparentprofits just before a proprietorsells hislher shares!)
14. Value stocks of finishedproductsat the current market sellingprice ratherthan at cost.
15. To impressone's bankers,one could holdback a week'soutputso whenthey visit the factory,
it appearsto be a hive of activity.
16. Set up a Department99 to invent somecustomersor some rice or ammoniaor vegetableoil.
If you need a ship to transportthese goods,or tanks to store them in, invent these too.
17. Set a sales target for a given area of your businessfor a year. If salesfall short of this target
by, say, 20 per cent, take 20 per cent of that area's expenditureout of the current year's
accountsand defer it to next year.
1.S.Do not revalue your assets so, although your provision for depreciation looks adequate
comparedto their book value, in fact it is much too low.
FIGURE 2.1 Creative accounting techniques

Source: Extract from J. Argenti 1976, Corporate Collapse: The Causes and Symptoms, McGraw-Hili,
London, pp. 141-2.
7. Check the cooperation of the applicant. When a party is willing to provide

whatever information is requested without any hesitation, or volunteers infor-
mation, there is no cause for worry. Where a party avoids or delays giving
information before or after a loan is approved, then be suspicious. In the
matter of HIH, Mr Graeme Thompson of the Australian Prudential Regulation
Authority stated 'the actual trigger for that was the fact that the company was
overdue in providing its December statistics to us and that was the particular
trigger that we had under the Insurance Act to issue a Show Cause Notice
which we did at the beginning of March' (Pascoe 200Ib, p. 1).
Given the magnitude of the {Alan} Bond empire and the nature of its dealings
something.as marginal as the Manet charge seemed an act of desperation. The
law seemed to behaving even more trouble with Bond than his shareholders had.
In December 1993 Bond's Jawyers successfully applied for a six-month stay of
proceedings On that the former tycoon was 'fragile and vulnerable'
and that his mentalca:padties had collapsed so far under pressure that he 'would
have difficulty corner store'. His mental incapacity was said to be such
that he was unable 10 .instruct his lawyers properly. Melbourne psychologist
Timothy Watson",M:unro testified that Bond had a high IQ but had lost the
capacity for as demonstrated by a loss of vocabulary and basic
numeracy. The ollset:o:fthis malaise must have been sudden, because only four
months earlier Bond's laWyers had been well enough instructed to threaten libel
suits against anotherjoumalist and myself. The court was sufficiently impressed
by the seriousne$s· of Bond's ailment to postpone hearing of the Manet charge
frQroJanuary 1994 to July.
By late June. however, magisterial tolerance had expired. Perth magistrate
Ivan Brownorde:red Bond to face court. Brown said he accepted some damage
had been done to Bond's brain during surgery but said the damage was 'micro-
scopic', At the Start of 1995, the authorities finally got serious, charging him
. With six offences relating to the lending spree by Bell Resources. Tony Oates
and Peter. Mitchell - both of whom had been living overseas for several years
- were charged in absentia with the same offences. In January 1996, Bond and
Mitchell (who had returned from the United States to face the charges) were
committed for trial on the Bell charges. Oates, still living in Poland, had not
been formally charged.
Biographies of Bond invariably list his greatest achievement as his Victory in
the America's Cup. It is certainly true that the historic win gave the ..
huge surge of national pride. But the price was equally huge. When
crossed the finishing line at Newport in 1983 Bond Corporation's de
around $200 million. As shareholders' funds were stated at $250 million,
looked reasonable. Over the next six years the Bond group's borrowings multi-
plied forty-fold to $8.5 billion. Admittedly, this included the borrowings of
companies Bond took over - such as the Bells - but he also took over their
assets. By the end of the six-year period, his shareholders' funds were severely
negative, making him hopelessly overgeared ....

needs to be read
. optimistic view of asset
The most astonishing
five years. Even allowing for
..took over this is a staggering
ex.dulde:d;.l only a relatively modest rise in
1984 and 1965 i wlUle in 1989 they went negative.:;:::;.
into Bond Corporation was producing little added.
value for shareholders. Meanwhile the gearing ratio steadily blew out every
year, making Bond Corporation an accident waiting to happen.
Bond Corporation gearingarid interest cover ($'000000) (a)
Yearto: 1984 1985 1986 1987 1988 1989
Gearing
1. Total assets 725 1262 2828 4116 9015 11 704
2. Debt (b) (382) (717) (1994) (2803) (5932) (8518)
3. Other liabilities (33) (49) (196) (194) (1l62) (1393)
4. Shareholders' funds CC) 240 308 538 747 891 (16)
5. Gearing (2:4) 1.6:1 2.3:1 3.7:1 3.8:1 6.7:1 nla
Interest cover
6. Revenue 365 517 1601 2489 5009 8482
7. Pre-tax profit (d) 18 33 136 184 326(e) (986)
8. Net interest paid (27) (60) (184) (206) (405) (744)
C+ 8
9. Interest cover -8- ) 1.5:1 1.6:1 1.7:1 1.9:1 1.8:1 nla
Notes:
(a) Conventional group consolidated accounts.
(b) Excluding trade creditors, but including convertible bonds in 1987 and 1988.
(c) Excluding minorities.
(d) Including extraordinaries.
(e) If the Kitool and Hilton deals were taken out, 1988 profit would fall to about $176
interest cover would fall to 1.4:1.
The pre-tax profit figure given in the table includes extraordinaries. This is
fair, because Bond Corporation was essentially a trader in extraordinaries. The
profits are unimpressive compared to either revenue or assets. They are even
more unimpressive to the analyst wll,o takes a more conservative view of the
treatment of some items, such as capitalisation;:Qf interest and other expenses.
For shareholders, the rewards were never to the risk. Despite the
sums they were given to play wftn;"the men at the top of Bond
Corporation could never generate decent earnings.
Bond was oftt:n called a visionary, but in pursuit of his visions he enriched
himself and his Coterie of directors at the expense of shareholders, and he rode
over the rights of minority stakeholders in his enterprises. They paid
a fiighprice for the l\1nerica's
.I
Cup .
Source: Extracprom T.Syk4.s 1996, The Bold Riders, Allen & Unwin,Sydney, pp. 237-8.
The 'Industry insight' on pages 76-7 highlights two important points for any
lending officer. First, the valuation of assets needs to be carefully investigated
and, second, a rising gearing ratio should set off alarms.
Useoffinancialratiosby loanofficers
Studies in the United States show that loan officers tend to prefer, out of the
many and varied financial ratios, the following ten financial ratios in loan
assessment and for inclusion in loan agreements.
TABLE 2.7 Financial ratios considered important by loan officers
Financialratios rankedin terms of importancein loan assessment
Financialratio Averagerating acrossrespondents
1. Debt/equity 8.71
2. Current ratio 8.25
3. Cash flowlcurrent maturities of long-term debt 8.08
4. Fixed charged coverage 7.58
5. Net profit margin after tax 7.56
6. Net interest earned 7.50
7. Net profit margin before tax 7.43
8. Degree of finandalleverage 7.33
9. Inventory turnover in days 7.25
10. Accounts receivable turnover in days 7.08
Key to rating
0, 1, 2 -low importance
3,4,5,6 - average importance
7, 8, 9 - high importance
Financialratios rankedin terms of percentageinclusionin loan agreements
Financialratio Percentageinclusion in loan agreements(%)
1. DebtlEquity 95.5
2. Current ratio 90.0
3. Dividend payout ratio 70.0
4. Cash flow/current maturities oflong-term debt 60.3
5. Fixed charge coverage 55.2
6. Times interest earned
52.6
7. Degree of financial leverage
8. Equity/assets 44.7
9. Cash flow/total debt 41.0
10. Quick ratio 36.1
33.3
Source: Gibson 1983 in G. Foster 1986, Financial Statement Analysis, Prentice-Hall, New Jersey,
p.580.
In many loan decisions, financial information about the applicant can be pur-
chased from firms such as Dun & Bradstreet and other credit rating agencies. A
sample report is reproduced in figure 2.2 (opposite). (The website of Dun &
Bradstreet gives details of its products, including its credit rating services.)

Asia-Pacific Credit Rating Agency
Sample commercial credit report
BASIC INFORMATION ABOUT THE COMPANY
Name of the company: Aditi Computers Limited Establishment: 12 July 1982
Fulf address: 8 Indraprastha, Gananjaya Street, Canberra 2913
Telephone: 61 2 6242 0689 Fax: 61 2 6201 5489
Web: www.aditLcom.au Email: aditi@aditLbigpond.com
Managing Director: Ms Aditi Sathye
Chair: Mrs Suneeta Sathye
BUSINESS INFORMATION ABOUT THE COMPANY
Major business activities: Software solutions
Major buyers of company products: Microsoft Corporation, IBM, Oracle
Major suppJier to the company: International Computers Limited, Japan Computers
Head office: Canberra; Branches: New York, London, Paris, Geneva, Pune
Number of employees: 334 at head office; 50 at each branch
Total revenue (2002): $130 million Net worth: $220320; 563
COMMERCIAL CREDIT RATING INFORMATION
Asia-Pacific Credit Rating Agency (APCRA) calculates credit score based on the information
available on its database. Utmost care is taken to ensure the information is valid and up to
date. The credit score is calculated using the statistical models developed by APCRA. The
score is the possibility of the firm delaying payments beyond a reasonable period of, say, two
months.
Credit score group: A (on scale A-M, where A indicates excellent credit standing and lowest
risk, while M indicates highest risk group)
Comparative credit score: The firm is in top 10 per cent of all the firms on our database in
group A. The top 10 per cent firms on our database are those that are rated as very low risk
firms.
Commercial credit score: 9 (on a scale 1-100, where 1 represents lowest risk and 100
represents highest risk)
Past history of delayed payments: Never
Maximum credit allowed: $50000000
(continued)
ANALYSIS OF ABOVE COMMERCIAL CREDIT RATING
APCRA arrived at the above scoring after consideration of several quantitative and qualitative
factors and information gathered from various sources. Major factors considered include, but
are not restricted to, the following:
a The financial condition of the company is excellent. The company has shown a
rising turnover of business and consistent and growing profits since its incorpor-
ation twenty years back.
b The Managing Director has a very high standing in the area of software solu-
tions and is widely regarded as an authority in this area. She has an excellent
team of dedicated and well-paid staff.
c Payment information indicates absolutely no adverse comment.
d The company was never subjected to any lawsuits and is known for its fair
dealing.
e Payments have never been delayed beyond sixty days in the history of the
company.
OTHER SIGNIFICANT INFORMATION
The company has applied for listing on the New York Stock Exchange.
FIGURE 2.2 Sample credit scoring report
Can financial ratios help in predicting corporate failures? Professor Altman

used financial ratios to predict corporate bankruptcy by using a statistical
technique of multiple discriminant analysis (known as the Z score model).
He examined twenty-two financial ratios and found that five of these put
together have the highest capacity to predict corporate failure. The five ratios
are: the working capital-total assets ratio, the retained earnings-total assets
ratio, the market value of equity-book value of debt ratio and the sales-total
assets ratio.
.·•. [statement of financial

some extent discretionary.
d1\icrttiOnary items is officers' compen-
pa;rUlillll:y
eanmaterially affect a company's bottom

[Below) is a condensed income statement for ABC Company (a retail jewelry
store) and the RMA common-size figures found on page 897 of the 2000-01
RMA Annual StatementStudies.
, "
'ABC Company's pre",taxnet income appears to have fallen from $290 000 to
$40 000. Sec<>ndly,dts common-size pre-tax net income appears to have fallen
to 1.0 per ceIlt,whfch is well below the RMA industry average of 3,6 per cent.
observation is correct.
In the 2000 income statements, the only difference between
the two years compensation, which increased Significantly - from
$250 000 to
Cost of goods sold

= Gross profit $1600 40.0% $1600 40.0% 39.8%
Operating expenses $910 $910
Officers' compensation $250 $500
Depreciation $50 $50
Interest expenses $100 $100
=: Total expenses $1310 32.7% $1560 39.0% 36.2%
Pre-tax net income $290 7.3% $40 1.0% 3.6%
In closely held companies, the ability to adjust owners' compensation can

make net income appear to be better or worse than it really is. If the 1999 and
2000 income statements were reversed, would you really want an .•
conclude that ABC Company's profitability was improving just be<:a.'tll!se,ttl
owners took out less in wages? I'm sure the answer to that is 'no'.
A better way to measure a closely held company's profitability is to use the
following formula:
Net income Officers' D . t' Profitability
before taxes + compensation + epreCla lOn = measure
Please note that this formula is not to be confused with traditional cash flow.
The traditional cashflow calculation would not include adding back officers
compensation and would include adding back interest expense. The formula for
profitability measure simply tries to more accurately depict a closely held com-
pany's relative profitability when noncash items and officers' compensation are
taken into account.
If you were going to buy a business and wanted to know the trend in that
business's profitability, what would give you the most accurate picture? Would
(continued)
you be willing to pay more for a company whose profitability was increasing
solely because the owner was taking less in compensation each year? No, you
wouldn't.
Applying this formula to the above statements yields the following statement.
This makes it clear that ABC Company was equally profitable in each period.
ABC Company
($'000) FYE1999 FYE2000
Net income hefore taxes $290 $40

+ Officers' compensation $250 $500
+ Depreciation $50 $50
= profi tabi Ii ty measure 5590 $590
Now the remaining question: 'How does one relate this to the RMA
common-size numbers?'. Most people know that the common-size income
statement appears in the Income Data section of each Statement Studies page,
but what one may not have noticed is that the final two ratios on each Statement
Studies page are '% Depreciation/Sales' and '% Officers' comp./Sales'.
These numbers are, in effect, the breakout of depreciation expense and offi-
cers' compensation on a common-size basis and can be incorporated into the
common-size income statement in the Income Data section.
Restating the income statement on a common-size basis and including the
median percentages from the '% Depreciation/Sales' and '% Officers' comp./
Sales' ratios in the Statement Studies results in the following:
ABC Company
RMAcomparison
SICcode# 5944
($'000) FYE1999 FYE2000 Sales$3 million- $5million
Sales 100.0% 100.0% 100.0%

Gross profit 40.0% 40.0% 39.8%
Officers' compensation 6.3°Ic, 12.5% 4.5%
Depreciation 1.2% 1.2% 0.6%
Other operating expenses 25.2% 25.3% 31.1%
Total expenses 32.7% 39.0% 36.2%
Pre-tax net income 7.3% 1.0% 3.6%
Applying the profitability measure then yields the following:

ABC Company
RMAcomparison
SICcode# 5944
($'000) FYE1999 FYE2000 Sales$3 million- $5 million
Pre-tax net income 7.3% 1.0% 3.6%
+ Officers' compensation 6.3% 12.5% 4.5%
+ Depreciation 1.2% 1.2% 0.6%
= Profitability measure 14.8% 14.7% 8.7%
I 82 Pari2: Analysisandinterpretationof creditrisk I

So what does this tell us? First of all, we find that ABC Company's common-size
profitability was the same in 1999 and 2000. Secondly; it tells us that ABC is
more profitable on a common-size basis than the median company that is
reflected in the Statement Studies.
In fact, the conclusion one would draw when comparing ABC Company's
common-size profitability to the Statement Studies figures when using the
profitability measure formula is exactly the opposite of the conclusion one
would have drawn regarding profitability if profitability measure were not
used.
The example given in the statement above (applying the profitability
measure), which oq:urs frequently in closely held companies, demonstrates
how misleading just looking at the bottom line of a company to assess its profit-
ability can be. Other misleading situations include overpaying or underpaying
rent payments to a related real estate holding company or underpaying or over-
paying for inventory from a related company. In these situations, depending
upon the objectives of the owner, he or she can make profits improve or decline
in either of the related companies.
When assessing a company's profitability, particularly a closely held com-
pany's, you must keep your eye out for expense items that may have a discre-
tionary aspect to them. If you don't, as the figures in this article demonstrate,
you could end up drawing the wrong conclusions.
Source: F. Dilorenzo 2001, 'Getting behind the numbers', The RMA Journal, 83(7), pp.51-3.
limitationsoffinancialstatements
analysiS
Financial statements analysis can be a useful tool, but it is no substitute for a
lender's judgement. Results of such analysis must be read with care. The
following are limitations of financial statements analysis:
1. Problem with benchmarhs. Many firms have product lines that span a range
of industries. The diversity of products makes it hard to develop suitable
benchmarks against which to evaluate finn performance. Average ratios for
firms within the industry may be available, but not the dispersion thereof.
This makes the use of benchmarks less reliable and less useful.
2. Window dressing. The problem of window dressing has been considered
earlier in this chapter.
3. Historical data. Ratios are calculated using historical financial statements.
Unless the figures in the financial statements are marked to market, it is
hard to obtain a true picture. Further, the lender is interested in obtaining a
futuristic view and it may not be correct to predict the future on past trends
alone.
4. Qllalitative aspects. This type of analysis ignores qualitative aspects such as
the quality of management, regulatory changes and changes in the domestic
and international economi.es.
Summary
1. What are the hey financial statements?
The key financial statements used by lenders include the statement of finan-
cial position, the statement of financial performance, the cash flow statement
and the statement of changes in owner's equity.
2. What is the importance of financial statements analysis in lending decisions?
Such analysis is conducted to find answers to three important questions facing
a lender. Should the financial institution give the requested loan? If the loan
is given, will it be repaid together with interest? What is the financial insti-
tution's remedy if the assumptions about the loan turn out to be wrong?
.3. What are the various methods of analysis of financial statements?
Financial statements analysis can be broadly classified as cross-sectional
analysis, time series analysis and a combination of financial and nonfinancial
information.
4. What are the special techniques of analysis used in project finance?
Where a large quantum of loan is involved (for example, project finance),
lenders resort to project evaluation techniques. These include the payback
period, the accounting rate of return and discounted cashflow techniques.
Sensitivity analysis, break-even analysis and simulation help in assessing
project risk.
5. How can window dressing and fraud tahe place in financial statements?
Window dressing and fraud usually takes place in the valuation of assets, and
there are many ways in which these can be detected.
6. What financial ratios are generally used by loan officers?
Studies in the United States show that loan officers generally prefer ten types
of ratio in credit assessment.
7. What are the limitations of financial statements analysis?
The limitations are that: benchmarking can be difficult; window dressing
may occur; it is hard to obtain a future view; and this type of analysis ignores
nonfinancial information.
terms
accounting rate of return, debt-equity ratio, p. 57 margin of safety, p. 48
p. 63 discounted cashflow, net present value, p. 63
benefit-cost ratio, p. 63 p. 63 payback period, p. 63
break-even, p. 48 efficiency ratios, p. 49 profitability ratios, p. 49
cash break-even point, interest coverage ratio, ratio analysis, p. 49
p. 68 p. 57 sensitivity, p. 48
common-size statements, internal rate of return, simulation, p. 65
p. 49 p. 63 time series techniques,
cross-sectional leverage ratios, p. 49 p. 49
techniques, p. 49 liquidity ratios, p. 49 window dressing, p. 73
I 84 ParI2: Analysisandinterpretationof creditrisk I

Discussion
questions
1. What characteristics should a business have before it can be considered
to be financially sound?
2. What are the various types of financial ratio that lenders use in ana-
lysing the financial position of a firm?
3. Explain the advantages and limitations of financial statements analysis.
4. What is break-even analysis? Why should a lender be interested in
break -even analysis?
S. What is the difference between indexed analysis and common-size
analysis?
6. What is discounted cashflow? What are the various discounted cash-
flow methods?
7. What is 'creative accounting'? Explain by giving examples.
8. Which ratios do loan officers generally use in credit assessment?
9. Imagine the current assets and current liabilities of a firm are $3200 and
$2000 respectively. How much can the firm borrow on a short-term
basis without reducing the current ratio below 1.S?
10. Read the comparative statement of financial position (below) and the
statement of financial performance (page 86) of Imaginary Computers
Limited. Prepare a credit assessment report using the techniques of
financial statements analysis as explained in this chapter. Comment on
the financial strengths and weaknesses of the firm.
Imaginary Computers Limited
Statement of financial position as at 31 December ($'000)
2001 2002 2003

Share capital 5.3 7.5 8.5
Reserves and surplus 6.7 5.7 7.4
Long-term debt 4.1 3.2 4.2
Short-term bank borrowing 5.6 5.2 7.2
Current liabilities 3.4 6.5 5.6
Total 25.1 28.1 32.9
Net fixed assets 17.4 21.8 26.1

Cash at bank 2.6 0.8 1.2
Receivables 3.5 2.8 2.9
Other assets 1.6 2.7 2.7
Total 25.1 28.1 32.9
Imaginary Computers Limited
Statement of financial performance for the year ending 31 December ($'000)
2001 2002 2003
Net sales 29.8 34.9 57.4
Cost of goods sold 24.5 26.2 45.8
Gross profit 5.3 8.7 11.6
Operating expenses 3.7 4.2 7.0
Operating profit 1.6 4.5 4.6
surplus/deficit 0.2 0.1 0.4
Earnings before interest and tax 1.8 4.6 5.0
Interest 1.0 0.9 2.0
Profit before tax 0.8 3.5 3.0
Tax 0.6
Profit after tax 0.8 2.9 3.0
Dividends 0.6 0.6 1.1
Retained earnings 0.2 2.3 1.9
References
andfurtherreading
Argenti, J. 1976, Corporate Collapse: The Causes and Symptoms,
London.
Bernstein, L. & Maksy, M. 1994, Cases in Financial Statement Reporting and Analysis,
Irwin, Illinois.
Bernstein, L. & Wild, J. 1998, Financial Statement Analysis: Theory, Applications and
Interpretation, Irwin Singapore.
Clemens, J. & Dyer, L. 1986, Balance Sheets and the Lending Banker, Europa, London.
Coastales, S. & Szurovy, G. 1994, The Guide to Understanding Financial Statements,
New York.
Foster, G. 1986, Financial Statement Analysis, New Jersey.
Gibson, C. 1992, Financial Statement Analysis, South Western, Cincinnati.
D. 1998, Financial Statements Oemystified, Allen & Unwin, Sydney.
Horngren, C. & Sundem, G. 1994, Introduction to Management Accounting,
Prentice-Hall, New Delhi, India.
Herridge, R. 1993, Believe No-One, Little, Brown Co., London.
Jubb, P, Haswell, S. & Langfield-Smith, I. 2002, Company Accounting, Nelson
Thomson Learning, Melbourne.
Pascoe, M. 2001a, Business Sunday interview with Tony Mcgrath, provisional liquidator
'CfHIH, 18 March, www.finance.ninemsn.com.au/business sunday/interviews/ stories/,
accessed 23 May 2001.
Part2: Analysisand interpretationof

Pascoe, M. 2001 b, Business Sunday interview with Graeme Thompson, chief executive
officer, Australian Prudential Regulation Authority, 18 March, www.finance.ninemsn.
com.au/businesssunday/interviews/, accessed 23 May 2001.
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Finance, Irwin McGraw-Hili, Sydney.
Price Gittinger, J. 1976, Economic Analysis of Agricultural Projects, Economic
Development Institute, World Bank, Washington DC.
Sykes, T. 1996, The Bold Riders, Allen & Unwin, Sydney.
Weaver, P. & Kingsley, C. 2001, Banking and Lending Practice, Lawbook Company,
Sydney.
Introduction
In chapter 1, it was indicated that credit scoring techniques are increasingly being
used by lending institutions for credit assessment. In this chapter we will look at the
evolution and application of various statistical credit scoring techniques. Statistical
credit scoring allows for rigorous and disciplined decision-making. Other chapters
discuss the techniques and products available to a modern financial institution; this
chapter discusses analysis within a centralised model that can be overlaid across the
whole organisation to reduce the potential for error in credit scoring.
Statistical credit scoring has been a popular analytical tool of financial insti-
tutions since the mid-1980s, fuelled by the explosion of technology and the
ability to apply computer solutions to human problems. It is important to
realise, however, that the concept of credit scoring has been around for as long
as credit has been extended. There have always been criteria on which credit
decisions have been made and loans have been extended or rejected. These cri-
teria were based on comparison and lending to the best risk. What separates the
scoring techniques of today from those of yesterday are the reliance on tech-
nology and statistical analysis, and the downgrading of the loan officer (in the
consumer market) to a sales representative.
Overview
Since the early 1950s, per person outstanding credit in developed countries has
risen exponentially and has continued to increase in velocity. The old systems of
manual scoring are no longer affordable. The increase in credit applications coin-
cided with the evolution of computer technology. This change not only offered
a \vay to speed up the process of credit scoring but also provided organisations
with a tool that could be used to expand business. As demand continues to
increase and the need for timely credit decisions creates pressures for perfor-
mance within a highly competitive system, statistical credit scoring will become
increasingly important because it allows a lower cost structure to be overlaid on
the pricing of the loan. This pricing aspect can ultimately mean the difference
hct'vvecn survival or failure within the financial institution's defined markets.
Credit scoring as used today is a statistical method of ranking the probability
oran unknown outcome (that is, a loan paid or a loan defaulted) by allocating
a poi nts system to known variables. The credit information of an applicant is
asc,csscd and gradcd numerically to gain a total score, which is then ranked
according to the expectations of the financial institution. A critical aspect of
scoring is that it should not discriminate on the grounds of sex, race or religion,
and credit should not be refused on the sole basis of location. Ultimately, a valid
c,tatistical credit scoring system exhibits the following three basic characteristics.
I. It must not rely on prohibited information, and the information used must
be statistically justified.
2. The information used should contribute pOSitivelyto a client's creditworthiness.
3. The credit extended should contribute to the credit health and quality of the
lending institution.
The ultimate aim of any credit scoring technique is to improve the quality of
the loan book that a financial institution maintains. Statistical credit scoring is
widely used in the consumer and small business areas, and is progressively
being implemented across the larger business and corporate sectors. Changes to
credit scoring methods are being progressively introduced as financial insti-
tutions continually re-engineer processes and practices for the ultimate aims of
efficiency and productivity.
Credit scoring techniques, as statistical measures, can forecast a probable
result, depending on the accuracy of the data on which the system is based.
There is still a real need for active management and timely intervention if the
true state of the loan diverges from the statistical prediction.
Thedevelopment
ofstatisticalcreditscoring
Credit scoring as a measure of loan success in its modern form began about
thirty years ago, and it has evolved and matured alongside the evolution of
computer technology. The development of scoring systems continues to parallel
the increase in per person outstanding credit, the expansion of the credit
industry and the drive for cost reduction and productivity.
The evolution of credit scoring reflects not only the growth of credit, but also
a reaction to the need to differentiate and recognise population subsets where
only related characteristics are immediately apparent (in other words, where the
characteristics that separate the population are not obvious). Durand (1941)
was the first person to recognise that the idea of discriminating among popu-
lation groups (first introduced by Fisher in 1936) as a pure statistical tool could
be used to identify good loans and bad loans (Thomas 2000). Consumer credit
expanded rapidly in the 1960s with the introduction of credit cards and the
ability to use future money or earnings for small consumer purchases. Financial
institutions realised the advantage of an effective scoring system, initially based
on manual completion and certification. Technology supplied the missing link
in the 1980s as the volume of applications outstripped both economic and
staffing resources within institutions. The scene was set for even more rapid
expansion of credit and, in turn, the further development and sophistication of
the credit scoring techniques.
The implementation and acceptance of scoring was not an easy transition
because many traditionalists opposed the idea of a statistical measure applied
arbitrarily across the whole population. Capon (1982) argued that 'the brute
force empiricism of credit scoring offends against the traditions of our society'.
He felt that there should be more dependence on credit history and that it
should be possible to explain why a scoring system needs certain character-
istics and not others. This view was more than offset by evidence that the
default rate would drop by more than 50 per cent. Reports from Myers and
Forgy (1963) and Churchill, Nevin and Watson (1977) cleared the way for
wholesale implementation of the process within a large range of financial
institutions. They were able to demonstrate that statistical credit scoring

models would not only add value to the credit analysis process, but also add
rigour through the application of probabilities and measurable outcomes. Most
of the developed world has introduced legislation that makes it illegal to dis-
criminate in the granting of credit unless the reason for credit refusal can be
statistically proved or supported.
The success of the application of statistical credit scoring techniques in the
credit card market made it inevitable in the 1980s that financial institutions
would expand their use into other areas, including personal loans, housing
loans and small business loans. The techniques are now used for the full range
of lending products, from individual to larger corporate loans.
There are many reasons for the success of statistical credit scoring. Once the
system has been tested and put in place, it ensures more accurate risk identifi-
cation and significant cost reductions. There is also a substantial reduction in
the interaction between the lender and the applicant, allowing for more time to
be spent on developing the relationship and less time on number crunching or
negative activities. Successful application of a statistical credit scoring process
also allows a financial institution to restructure its staff profile, with more
emphaSiS on sales. This leads to an increase in the availability of credit because
resources are released to deal with the increases in application volume. The
lowering of the staff experience level and profile can lead to the potential for
loan pricing to be discounted, with a proportion of the savings passed onto the
consumer.
Not all borrowers face a price reduction. Some will face a price rise because
credit scoring models are able to distinguish good loans from bad loans in a
non-emotional way. This ability to make non-emotional decisions will improve
in the financial arena. Historically, banks in particular have performed poorly in
their pricing decisions because they have had a 'one size fits all' mentality.
Advances in the field of credit scoring have allowed accurate forecasting of
portfolio values and, consequently, an increase in the securitisation of lower
level financial products.
With the success in the consumer market, it was inevitable that the same pro-
cesses and procedures would be re-engineered for the small business market.
Now, the same degree of savings and efficiency gains are being reaped in this
important area of lending.
Thebehavioural
aspectsofcreditscoring
The financial environment has been in constant change for the past twenty
years, as old methods are replaced with new ones. The new methods are usually
technology based to ensure an adequate return of shareholders' funds can be
achieved economically. Judgemental decision-making versus credit scoring has
been a source of tension within banking circles since the latter's full introduc-
tion. Traditionally, banking has been about judgement and contact, with the
relationship between the banker and the customer a paramount business con-
cept. The bank manager used to be the human face of the bank and also the
decision-maker in the majority of contacts.
Times change. The old-fashioned way of banking has ceased in the face of the
techniques that evolved from the 1980s. The concept of a fully fledged bank
manager waiting to service the needs of the client were too expensive in the
brave new world of finance. Technology was used to replace expensive finance
managers with new sales-focused staff. These sales staff use analysis techniques
to score a proposition that can be passed up the line for approval. The link
between the manager, as the decision-maker, and the client has become redun-
dant as new methods evolve to ensure financial institutions remain profitable,
and as technology and process replace judgement and relationships. Today's
sales force can enter into many more transactions than were possible under the
old regime, simply as a result of the application of credit scoring techniques.
Credit analysis is about risk management. The judgemental approach built
very sophisticated techniques for analysis, with many checks and balances built
into the system. The successful functioning of that system depended on the
individual lender being a highly trained individual who supported the network.
Credit scoring has supplanted this individual. It is risk management by design,
allowing costs to be reduced and businesses to expand at a previously impos-
sible rate. Other behavioural reasons for the implementation of credit scoring
included the breakdown of the judgemental system during the 1980s due to the
frantic drive for market share and the worldwide deregulation of the financial
system. The 1980s were a watershed in the development of the modern finan-
cial system. Banking and the environment of banking had changed little in the
previous fifty years; processes and procedures had remained constant. Deregu-
lation was also an irresistible force, as countries across the globe removed
restrictions on capital movements and exchange rates.
Australia was one of the leading proponents of deregulation. We were faced
with a choice: deregulate and modernise or place higher barriers to market
entry. Australia chose to deregulate and modernise, which was the right
decision because our economy has grown rapidly in the intervening years to be
about twenty times larger today than it was in 1981. This environment of
change and the entry of new competition in financial markets forced the
existing players in Australia to respond, first in the drive for market share and
second in the maintenance and growth of value for shareholders.
Theimperative
forcreditscoring
A major problem in Australia in the search for the perfect credit scoring system
is the small size of the population for analysiS. Implementation of credit scoring
within financial institutions in the 1990s nevertheless led to a significant reduc-
tion in the volume of bad debts within the consumer market. Banks realised
that credit scoring enabled them, for the first time, to have a true measure of
risk in a given loan portfolio. Once a true measure could be set, then the next
step was to implement a standardised form of control and monitoring by senior
management. In other words, losses within a given loan portfolio can now be
predicted with a certain degree of accuracy. Competitive advantage, beyond just

the individual safety of the loan, is derived from the cost savings and efficiency
gains that credit scoring techniques can generate.
Dun &: Bradstreet developed a set of criteria that justify the imperative for
statistical credit scoring (Thomas, Crook &: Edelman 1992). The application
of strong statistical tools helps reduce the cost of credit analysis and, in
standardising the process, apply more rigour to the overall loan portfolio. The
process extends to allow for market segmentation of the total loan book, such
that cross-subsidisation can be identified and eliminated. First, a test score
result is compared with actual operator analysis, to identify and verify statisti-
cally the accuracy of the system. Once this verification has been conducted
and validated, the system becomes an operational tool with little human
input. The process is updated on a needs basis. The cost of credit analysis is
thus reduced.
Correct application of statistical credit scoring techniques also allows for an
increase in revenue through the increased volume of credit applications. Faster
credit decisions allow for increased volume within scarce or existing resources,
which means the portfolio creation process is more productive and ultimately
more profitable. The consequent change to the staffing profile allows for the
loan book to grow without a subsequent growth in the cost of maintenance.
Statistical credit scoring models thus help lending institutions to cut costs
and increase their volume of new customers. Importantly, they can also be used
to check existing clients. The sale of products to existing customers can be
better monitored and expanded, and new client segments can be targeted with
applicable products. By applying better methods of credit analysis to new cli-
ents, statistical credit scoring techniques allow for quick and accurate segmen-
tation of customer groups and quick reaction to competitor action. They also
provide the potential to prioritise future collections or identified cashflows,
allowing for improved collection methods and cashflow management. Once this
potential is released, a financial institution can grow its portfolio by more effec-
tively using recurrent cashflow. Clients nominally share in the process and ben-
efits where a financial institution's continual improvement and cost reduction
lead to pricing discounts.
Given that the above principles represent the functions of a statistical credit
scoring system for a financial institution, a strong statistical scoring system has
the following advantages for an institution:
• Credit scoring can increase returns by identifying good versus bad
propositions based on the preferences and inputs of the financial institution.
• An accurate credit scoring system reduces credit risk to a significant degree,
or at least to a statistically accurate percentage of an outstanding loan book.
• Credit scoring saves time in considering new credit applications, which
allows for volume increases without necessitating personnel increases.
• Credit scoring allows increased flexibility and expansion in the area of small
and medium enterprises (SMEs). Again, this is based on the volume versus
resources argument.
• Where a poor credit score is calculated, the lender can take corrective action
in the case of existing customers or refuse new business from a potential
client.
• A stronger lender/customer relationship can develop from the ability of the
financial institution to predict performance. This feature can allow a modern
financial institution to service customers' needs, not their wants.
Brill (2001) noted:
They say past performance does not guarantee future results, but in the world of
credit decisions history often proves to be a reliable indicator. Credit scoring
models that measure the likelihood of delinquent payments using actual payment
history along with other financial and demographic statistics are familiar to most
credit managers as useful tools for pre-qualifying sales prospects and making
informed credit decisions. These days, however, credit managers are discovering
that the diSCiplined use of sophisticated statistical credit scoring models can also
create a Significant bottom line impact by improving cashflow and collections.
Statisticalcreditscoringtechniques
versus
traditionaljudgemental methods
In implementing and monitoring credit scoring techniques, it is important to
measure and ensure the validity and application of the assessment. When
applying a credit scoring system, the financial institution must clearly define
and understand the outcome. Statistical measures to be used must be verified as
to their applicability and alignment with traditional judgemental measures. It is
wise to compare a statistical system to a judgemental system to ensure the
credit scoring system adds value to the organisation. Any comparison between
the two systems will be in the eye of the beholder. Statistical systems score
highly when dealing with inexperienced staff and organisations. Experienced
lenders place a high value on judgemental methods, but the sales focus of the
modern financial institution mitigates against the development of experience.
Table 3.1 summarises the differences between statistical and judgemental credit
scoring techniques.
TABLE 3.1 Statistical versus judgemental credit scoring
Topic Statisticalscoring Judgementalscoring
1. Population difference Impractical or unsound Credit officers make an

mixtures of population are unspecified adjustment.
not sampled.
2. Definition of Precise corporate rules are The system relies on

creditworthiness defined and agreed. individual interpretation of
what is good and bad.
3. Use of credit rules Credit rules are avoided Credit rules are often based
because the system will on limited data that dwell on
generate its own 'best' rules. the past.

Topic Statistical
scoring Judgemental
scoring
4. Use of applicant Less information is needed Wide use is made of data that
information because redundant are sometimes conflicting.
information is ignored.
5. Analysis of account Analysis reveals distinctive Rarely is a precise or accurate

behaviour and objective patterns of analysis produced to guide
good and bad behaviour. the future.
6. Validity of characteristics The impact and validity of Decisions are made without
and interrelationships individual bits of information knowing the true value of
can be assessed. items of information.
7. Validation of system used Scoring formulations can be It is not practical to measure

tested against a variety of the precise effect.
samples for consistency and
prediction.
8. Operational impact! The system is based on high The system can be time
flexibility volume versus low cost. consuming and accordingJy
expensive.
9. Improved calculations Calculations can be made for It is difficult to estimate the

and expected results decisions on good, bad or value of a model to measure
reject behaviour. performance.
10. Management control Management sets and defines It is difficult to tighten or

policy by the ability to vary ease credit policy without
the cut-off score according to causing an overreaction or
conditions. underreaction.
11. Monitoring and wider Measures can be monitored The level of performance can
use against current practice and be measured but the financial
developmental models. institution has no ability to
easily pinpoint scope for
improvement.
Source: Adapted from L. C. Thomas, J. N. Crook & D. B. Edelman 1992, Credit Scoring and Credit
Control, Oxford Press, Oxford.
Several schools of thought exist in the development of techniques and

methods. Based on table 3.1, however, two broad categories of scoring can be
identified:
1. In accounting-based systems, credit analysis forms the basis for the model
and ratios are used as the base for analysis of data. Information can be gath-
ered independently or by access to prepared data from organisations such as
Dun &: Bradstreet, Standard &: Poor's, Moody's and Australian Ratings. The
basis of the analysis is to seek deviations from the average (or mean) that
generates questions or comparisons that the borrower must answer before
the lender commits to giving an advance. These models are univariate (one
variable) and have generated much debate about the continuing relevance of
analysis based on single factor analysis.
Although univariate models are still in use today, many practitioners seem
to disapprove of simple ratio analysis as a means of assessing the perfor-
mance of a business entity. Many respected theorists downgrade the arbi-
trary rules of thumb (such as company ratio analysis comparisons) that are
widely used by practitioners; instead, they favour the the application of more
rigorous statistical techniques (Caouette, Altman & Narayanan 1998). Some
examples are Altman's Z score model and its variants, the emerging market
score (EMS), the ZETA credit risk model (an evolution of the original Z
score) and the seven-variable model.
2. In quantitative credit screening, two broad streams have emerged:
(a) credit approval models, which use decision-reaching analysis
(b) behavioural scoring models, which are used to improve the profitability
of accounts and products.
Both categories rely on the use of statistical measures. The major difference is
the predictive nature of the accounting-based models as opposed to the
rear-view analysis of the quantitative models. In both cases, however, the aim is
to predict an outcome based on available information. We will now discuss this
second set of statistical credit scoring.
Statisticaldecision-making
methods
usedin
creditscoringmodels
Scoring models are designed to measure risk so the exposure of the lender can
be managed. The first stage of statistical analysis is the gathering of data. Con-
sider how much personal and financial information the average financial insti-
tution gathers from its customers. More often than not, the data are collected for
an administrative requirement; imagine if that information could be galvanised
and used for the safety of the institution. The real skill in any model is to identify
the information that is needed and to source data in a timely and productive
manner. Management information systems have been built progressively over
the past two decades to ensure the data are available and accessible. This infor-
mation retrieval aspect is one of the reasons that credit scoring has mushroomed
from retail to corporate use in sophisticated credit risk analysis.
The development of credit scoring hastened when the financial community
accepted the concept of uncertainty in the early I980s. The sector previously
assumed that risk was predictable given the regulated environment that existed
in the developed world. In the context of a deregulated environment, the risk
of a loan is the probability of the borrower making the repayment and the
uncertainty is the actual predictability of the borrower's future cashflows.
Credit modelling provides a statistical base to the predictive models. In other
words, risk and uncertainty are modelled to give a picture of future prob-
abilities. Different methods were developed to meet the various demands of the
end users (lending institutions), including the following thirteen main methods
described by Hoyland (1997).
96 ParI2: Analysisandinterpretationof creditrisk I

1. Probability modelling. This modelling predicts the future value of cashflows
and profit. The trend in the current business environment is for short-term
planning. This increases the uncertainty of the value of present profits
compared with the value of future profits. Financial institutions are in a
difficult position in that they are generally a corporate organisation and
exhibit the characteristic of short-term profit value manipulation, but they
must also ensure the safety of their long-term portfolio values to ensure
sustainability and viability as a financial institution. This is a fundamental
conflict within banking because the whole system depends on confidence
and the acceptance of liqUidity into the future. Financial institutions are
highly geared organisations compared with other business activities (such
as manufacturing enterprises). Accordingly, they need to chase growth and
profits in the short term, but risk continues into the long term until the
advance is repaid.
Probability modelling has evolved and changed to meet the demands of
the various products that have come on line in the financial arena over the
past decade. The basic process is about identifying knowns or controllables
(for example, credit risk stance and the allocation of credit pools) and
unknowns or uncontrollables (for example, interest rate costs and income
tax considerations). Once these variables have been set, the criteria are
entered into the model and the outcome is used to place the loan into a
risk profile. The ranking within the profile indicates to the lender the
acceptability of the loan according to the risk, allowing for differential
pricing within a single portfolio.
2. Application credit scoring models. These models evolved to meet the finance
industry'S demand to be able to measure uncertainty to some degree. They
are popular because they allow the reduction of labour costs and large
growth within the loan portfolio to occur at the same time, especially
because they are able to be managed centrally within a large organisation.
The foundation for building these models is taking past decisions, ana-
lysing the data available at the time of the decision and seeing whether any
lessons can be drawn from that decision. The scores are applied most easily
in areas where the businesses have been operating a consistent policy for
several years. A problem with these models, however, is that past data are
used to predict future outcomes. A successful model, therefore, has the
capability to incorporate a view of the future. This view needs to be broadly
based and capable of rigorous justification within the model setting.
3. Application derivatives. Credit scoring is a key need of the finance industry,
but predictive statistical models have other uses, including the following:
(a) Mail solicitation score. The use of mail as a cross-selling tool is rapidly
expanding. In almost every case, correspondence from a financial insti-
tution contains information about a variety of other products or ben-
efits. Data, including demand and demographics data, are readily
available. Given the repetition and volume of the data, results can be
compared across various campaigns.
(b) Attrition models. These models try to predict the success over time of
various products. They measure and project the life of a product and
the potential fall-off rate of use or cancellation by a given segment of
the user group. This form of measurement allows for preemptive actions
to ensure ongoing use and loyalty over the lifecycle of the customer and
product.
(c) Authorisation scores. Customers require the ability to spend their
money wherever and whenever they want. For them, money in the
bank is equivalent to the right to purchase. As the financial community
responds to the demands of customers for wider access to their funds,
credit risk is vastly increased. The real application of an authorisation
score is to identify nonfraudulent activities or traditional credit risk as
it is understood today. The financial institution exercises control in
that customers do not carry funds as cash but spend via electronic
funds transfer at the point of sale (EFTPOS). This method of payment
usually requires some form of authorisation before transfer: a personal
identification number (PIN) for transfers from savings and cheque
accounts, and a signature for a credit account transfer.
The real challenge of these models is to ensure a good client is not
disadvantaged and a bad customer is not given access to excessive
credit. The successful operation of an authorisation score relies on
timely access to relevant information about the borrower, and on the
ability to analyse the data quickly without the need for human
intervention.
4. Judgemental credit scoring. When new products are introduced, the data for
a full application model usually do not exist. Accordingly, a model is intro-
duced to attempt to alleviate the potential for loss. Financial institutions
like a minimum of three years information to enable accurate analysis. A
problem that may emerge with this analysis is the bias towards bad behav-
iour. In other words, the model may be conservative and skewed to the
identification of bad debts rather than the expansion of new business
opportunities.
5. Collection models. When a customer defaults on a payment or series of pay-
ments, the collection department takes over the management of the
advance. The collection department of a financial institution is charged
with finding a solution that either generates full repayment or minimises
the loss to protect long-term profit projections. The relationship with the
client will change, and legal obligations need to be factored into the
decision-making process and the model development. In the model devel-
opment phase, the lender must exercise care in identifying the expected
outcomes. The outcome can vary from preventing total default by ruthless
early term follow-up, to early warning leading, to total loan write-off. The
model parameters must be set and adjusted to meet the strategic expec-
tations of the financial institution.

6. Regression analysis. This linear statistical technique can be used to develop
a mathematical equation showing how different variable are interrelated.
The variable that is being predicted is called the dependent variable. The
variables being used to predict the value of the dependent variable are
called the independent variables. In credit scoring, this technique is based
on a set of observations that measure the ratio of the probability of default
to a value. The basic measure is a ratio of age to probability of default.
Problems that arise include missing or incomplete data and the potential
size of the population. The skill of the model builder is the main means of
alleviating these problems. Regression is probably the most widely used
and understood statistical technique in the building of credit scoring
models, but theoretically it is not the most appropriate.
7. Logistic regression. This method allows a direct estimate of the probability
of an event happening. The useful aspect of this technique is the ability to
develop a model that is capable of nonlinear analYSiS,which is made possible
by the use of interpolation or iterative methods. As with all techniques, there
are difficulties in applying logistic regression, including (a) the potential size
of the database in use and (b) the difficulty of manipulating the outcomes
due to the difficulty of amassing a sufficiently representative database.
8. Decision tree models. This approach categorises the attributes of the client
from most important to least important. The process of partitioning con-
tinues until the model contains sufficient branches to enable informed
deCiSion-making on a consistent basis. The genesis of this technique can be
traced to the 1960s. A computer-based system, it represents the infor-
mation diagrammatically and justifies the decision by eliminating fault or
potential pitfalls.
9. Neural networks. A different approach to credit analysis and scoring, neural
network analysis removes the bias towards linear analysiS for financial
decision-making. It is similar to nonlinear discriminant analysis in that it
removes the assumption that the variables entered are linearly and inde-
pendently related. A neural network is a collection of simple computa-
tional elements that are interconnected neutrons. In the brain, electric
signals passed between neurons are either inhibited or enhanced,
depending on what the neural network has learned in the past. In a similar
fashion, artificial neurons may be constructed using either hardware or
software to behave like the biological neuron (Hecht-Neilson 1988). The
links between the neurons are not rigid and can be modified over time
through the learning process or experience gained.
A neural network is a parallel distributed information processing struc-
ture consisting of processing elements interconnected with unidirectional
signal channels called connections. Each processing element has a single
output connection which branches out into as many collateral connections
as desired. The processing element's output signal can be of any mathemat-
ical type desired. All the processing that goes on within each processing
element must be entirely local (Hecht -Neilson 1988).
The value of these models over the more traditional ones is still
being debated. There appears to be only a small incremental gain in
the application of some of these variants. This form of analysis is
more difficult and therefore harder to interpret, which may result in
some slippage of the potential application process. Another reason for
the slow adoption may be the infancy of the computer technology in
the area of artificial intelligence, which represents the next giant
growth area of human understanding. Of all the alternatives available
for the development of credit scoring models, this area represents the
greatest potential.
10. Genetic algorithms. This system is a result of the research into artificial
intelligence and has its origins in the range of expert systems in use. To
understand this technique, it is wise to divide it into the following three
levels of activity.
(a) The system deals directly with the environment (as does an expert
system).
(b) The rules in the credit assessment mayor may not be correct to an extent.
In other words, review and evaluation of the rules are critical so the
decision factors are appropriate to the current environment (that is, a
rising or falling interest rate environment). It is vital that the rules are
constantly evaluated for accuracy and applicability.
(c) The system is capable of assessing the rules and, even after evaluation,
may generate new rules and some existing ones. In other words,
the system is capable of change and evolves according to the cumulative
experience of the system.
This new method of modelling risk and probability is difficult to
learn but will eventually find a direct place in the armoury of financial
analysis. Given the nature of the models, it is capable of being used in
areas where other models fall down.
11. Mortality models. The mortality rate model of Altman (1989) and the
ageing approach of Asquith, Mullins and Wolf (1989) are both based on
the capital markets. These mortality-default rate models seek to derive
actuarial-type probabilities of default from past data on bond defaults, by
credit grade and years to maturity (Caouette, Altman &: Narayanan 1998).
The challenge for the financial institution in implementing this sort of
model is the selection of a database of sufficient size for accurate
decision-making.
12. Chi-square automatic interaction detector (CHAID). This technique divides a
population into two or more distinct groups based on categories of the best
predictor of a dependent variable. It then splits these subgroups into
smaller subgroups based on other predictor variables. The splitting process
continues until there are no more statistically significant variables that can
be used to perform further subdivisions or until some other stopping rule
is reached. The subgroups that CHAID derives are mutually exclusive and
exhaustive, with the sum of the subgroups defining the original population.
I 100 Part 2: Analysisandinterpretationof creditrisk I

The CHAID model is a visual representation of data and has some degree of
commonality with decision tree analysis. Care must be taken to contain the
model because it can grow to unmanageable proportions.
13. Expert systems. Expert or artificial systems are computer-based decision-tree
support systems. They make deductive judgements based on the following
three major components.
(a) An information module. This module interacts with the user by question
and answer. This process continues until there is sufficient evidence on
which to base a reasoned decision.
(b) An information database module. This is basically a 'what if?' module
where the system uses the inbuilt decision rules to guide the system
through the decision-making process.
(c) A learning module. This model verifies inputs to ensure the integrity of
the system and allows for the evolution of the package. A basic assump-
tion is that the system can learn and develop over time in line with com-
munity expectations.
Socialandethicalissuesin applyingcreditscoringtechniques
All major financial institutions face a significant strategic challenge in weighing
up of the advantages of fully implementing credit scoring models against the
potential for the customer base to feel further alienated where it perceives the
institution is greedy and unable to meet client expectations. Financial insti-
tutions do not enjoy particularly high standing in the community in general,
which is a paradox considering the advantages that the financial system brings
to the economy. A financial institution needs to consider social issues in its
drive for efficiency and productivity; failure to address relationship issues will
result in a decline of market share, which can offset any gains accrued by a
mature statistical credit scoring system.
There is a corresponding relationship between the rigour of the assessment
and the production of good or bad loans; decisions need to be made on the
basis of available information. If a financial institution needs to be intrusive to
obtain the required information, then are the outcomes sufficiently beneficial to
outweigh the social impact or potential loss of reasonable business?
Lenders need to understand the ramifications of empirical systems versus
basic credit analysis and judgemental systems; failure to do so could result in
inappropriate analysis and deCiSion-making. Correct understanding allows a
financial institution to evaluate its value system and business base. A financial
institution must be fully aware of the operation of its statistical and judge-
mental credit scoring systems, and of the potential for the environment of pro-
cess decision-making to ignore the needs of the individual or market segment.
Lenders must address this potential for a distant and impersonal approval
system to evolve from a statistical credit scoring system. Centralisation can lead
to alienation of the client and staff, which is perhaps the most significant risk
faced in the implementation phase of any new scoring system. The creation of a
strong credit scoring culture forces decisions of judgement and delegation,
because central control is needed to ensure the veracity of the system. As safe-
guards, lenders can take the following steps:
1. Solve the problem of volume versus relationship. Planning of the statement
of financial position is essential for success.
2. Understand what the model is meant to achieve and its impact on the culture
of the organisation.
3. Understand type one and type two errors, which are the categories for the
basis of all hindsight analysis of loan books:
• type one - approval of a loan when it should not have been approved.
• type two - refusal of a loan when it should have been approved.
4. Remove the potential for bias in decision-making.
Implementing
creditscoringwithintheorganisation
The pay-off for an organisation that invests in the implementation of credit
scoring techniques can be dramatic. Some organisations have not achieved the
preconceived advantages, however, because they have failed to identify the
objectives of the process and the expected outcomes. The implementation of
the credit scoring process requires a marriage between technology and experi-
ence to produce a system that can standardise the loan approval cycle. This is
very difficult because technicians and practical lenders speak a very different
language. In the early days of implementation, a huge gulf existed between the
various interest groups, and that conflict meant the industry did not immedi-
ately gain the advantages of credit scoring.
G. Wilkinson, then of the Chase Manhattan Bank, identified a series of steps
that should be taken when developing and implementing a credit scoring
system (Thomas, Crook &: Edelman 1992). Adherence to the following points
should ensure at least a minimal understanding of how to implement and
develop a successful project plan for the implementation of credit scoring
within an organisation. It should also ensure the integrity of the final system
that is implemented.
It is essential that the board and executive management agree on project
objectives, costs and expected benefits. Failure to undertake this step will mean
the system is fatally flawed because there is no top-down support.
Correct and impartial selection of the implementation team or teams is essen-
tial for success. The make-up of the internal teams should be multidisciplinary
and the project leader must have defined responsibilities and reporting lines.
Selection of the internal developers and agreement on the project scope or
limitations will ensure implementation is within budgetary and time con-
straints. Development of an outline plan to make sure a project is properly
resourced, casted and completed in a timely fashion will allow for account-
ability and management. Different interest groups must define and agree on the
population to be addressed and its boundaries, based on commercial practica-
bility and basic statistical methods. This is an essential step to ensure correct
application of the process. In addition, the collection of preliminary data on
transaction volumes, rejection rates and levels of delinquency over time allows
I 102 Pari 2: Analysisandinterpretationof creditrisk I

for ongoing validation of the system. Investigation of data held by the compu-
terised customer accounting system helps ascertain whether usable character-
istic data are held and whether reliable and accurate definitions of good,
intermediate and bad loans can be generated. After the planning phase, it is
important to collect and analyse a pilot sample of accepted and rejected trans-
actions. Very obvious good and bad cases should be included to test the veracity
of the system.
The following steps are to be undertaken once the above activities have been
finalised:
• Review the implementation plan and agree on a definitive long-term plan
between the internal team and the external developers, if applicable. An
understanding of clear and measurable objectives is essential and the role of
each team must be clearly understood to ensure no overlap of functions.
• Construct and agree on robust definitions of good, bad and intermediate
transactions, and decide on the reference period from which samples are to
be extracted. Calculate good, bad, acceptance and rejection rates.
• Use definitions and a reference period to isolate and list individual
transactions to make up the large sample needed for later analysis.
Once the above steps have been completed, it is then essential to produce and
agree on preCise methods of coding a full list of direct and generated charac-
teristics without bias. It is important to pay particular attention to coding and
verifying the accuracy of any previous scoring systems. A detailed under-
standing of existing credit rules, which include previous attitudes and intuition,
is essential to allow the new system to reflect the values of the financial insti-
tution. These factors can be built in for later testing to verify the accuracy of the
previous system.
The lending institution must train and develop a clerical team that will
supervise the extraction of data, including information from application forms,
existing files and credit bureau data and rejects. The team must ensure the con-
sistency of similar data to standardise results. Samples must be codified
according to the predetermined rules and a database should be set up to
develop scoring formulations and comparisons. When this is done, the database
should be checked against predetermined error-checking and validation rules,
and the performance of good, bad and intermediate groups should be checked.
This function will verify the accuracy and rigour of the system, and allow the
implementation to move forward in a productive way with minimal waste of
resources. The following functions are to be carried out at this stage:
• Analyse all the characteristics in the main performance groups - good
versus bad and acceptances versus rejections - to identify the interactions
within the modelling capability of the program.
• Weight the sample counts of individual transactions using the information
obtained.
• Inform and discuss with management the results of testing and the progress
of the project.
After these tasks are completed, the project should continue with develop-
ment and testing. By carrying out the selected 'reject' inference process to test
the interaction of the variables and the operation and accuracy of the predictive
module, testers can assure the senior management team of the system's robust-
ness and ensure a smooth transition to a fully functioning model. Emphasis
needs to be given to the development of statistically sound and reproducible
characteristics, with emphasis on accuracy and a strong demonstrated ability
for management to understand the process. Senior management support at this
stage is essential to address and overcome resistance to change factors.
By testing the draft scoring formulation (by measuring and comparing the
predictive power to the validation sample), a valid score distribution for the
population can be derived with statistical accuracy. The construction of a strong
and supportive network allows for discussion of, and agreement on, the impact
of the scoring formulation. This impact is determined by comparing the current
and possible acceptance rates and bad experience estimates at various cut-off
points in the score distribution. The ability to demonstrate accuracy at this
stage of development will allow the process to move forwards with support. The
next stage involves the following actions:
• Formulate and refine future operational practices and build confidence in the
population sample by using the scoring formulation on recent applications
and collection transactions at various stages of delinquency, and then
comparing the results with expectations.
• Design and deliver the computer system to be used to support the accurate
operational use of the scoring formulations. At this stage, avoid totally
manual scoring unless forced to do so.
• Produce and discuss with management some three-dimensional illustrations
that show the effect of individual characteristics in the database on rejection
and bad experience rates.
Next, develop and agree on a cut-off strategy, building in factors such as
exceptions and any override rules based on profitability expectations. Mar-
keting and collection impacts can be built into the system with statistical accu-
racy, and developers can define, test and document internal management and
clerical training programs that aim to build confidence in the system and ensure
its accurate operation.
The developers must also design, check and introduce management control
information packages to monitor applicant profiles and subsequent bad perfor-
mance to ensure the statistical scoring system operates as expected and required
by the financial institution. A huge risk here is that the system will have been
designed by informational technology developers with only limited input by
management, potentially resulting in an expensive flop. A review process must
be set up to ensure the system is valid - that is, it has been produced to do
what the institution expects it to do, and it does perform those functions.
The above steps demonstrate the need for detailed planning in the implemen-
tation of a credit scoring system. It could be argued that we are beyond this
phase in a modern financial institution, but the past is a predictor of the future.

As the process evolves and matures from consumer lending to the SME sector
to the corporate sector, we need to revisit the implementation process to ensure
the potential for success with minimal resource implications.
A key characteristic of successful statistical credit scoring is the ability to
assess unknown individuals and obtain a consistent grading in performance. As
this scoring system extends through to the corporate sector, it becomes critical
for that system to function optimally to ensure the survival of the financial
institution. In other words, as the system becomes more sophisticated in its
operation and increased reliance is placed on the computer-based packages, we
need to ensure a strong fundamental human understanding of how the process
works. This understanding is necessary to prevent the financial institution from
becoming exposed to a knowledge drain where it is captive to the system and
incapable of reversing the spiral to financial disaster.
Sophisticated and accurate scoring systems are essential for the success of a
modern financial institution; without them, costs would blowout and insti-
tutions would be incapable of generating the growth needed in today's competi-
tive world. In this chapter, we have looked at the development of scoring
systems and how they create a new and different credit culture within lending
institutions. With the need for financial institutions to continually increase the
velOCity of the statement of financial position to be profitable in a highly geared
industry, any mechanism that increases productivity is much desired. This is the
competitive imperative for credit scoring. A further imperative is the need for
scoring to overlay all facets of the loan book and also other functions of a
modern organisation.
We have looked at the development of credit scoring and how it has evolved
to become a fundamental tool of the modern financial lending institution. It is
important to realise that scoring systems exist to manage risk of various kinds.
Consumer credit has exploded and continues to grow. It is vital to implement
systems that allow this growth to occur without degrading the loan portfolio.
Credit scoring extends well beyond just loan applications; a financial institution
uses many variants (as described in this chapter) to measure and manage large
customer segments.
A successful financial institution of today and the future embraces scoring, in
all its variants, as a competitive edge that enables it to meet the needs of volume
analysis but at the same time ensure its customer base is serviced to the point
where clients become advocates. This process over time has the ability to
restore the standing of the financial community in the eyes of the consumer.
Summary
1. Why were credit scoring techniques developed?
The evolution of credit scoring was based on the growth of credit and the
need to generate information about different business segments. With the
increasing demand for funds, old systems and methods no longer coped with
the volume of processing.
2. What are the behavioural aspects of credit scoring?
Technology has superseded the link between the bank manager and the
client. The old-fashioned style of management has been replaced with a sales
force devoted to business development and growth, with other personnel
being responsible for detailed credit analysis.
3. What was the imperative for credit scoring?
The need to manage default risk within a market that was growing in
demand and volume meant that cost-efficient methods had to be developed
for asset protection. This need coincided with the realisation that write-offs
could be mathematically measured and controlled.
4. How are credit scoring techniques applied?
Generally accepted methods of credit scoring in the modern world are
statistics based. Application is based on a disciplined and sophisticated
approach that is designed to add value to the financial institution.
5. What modelling techniques are used for credit scoring?
Two distinct major models are in use: statistical scoring techniques and tra-
ditional judgemental methods. Statistical methods are numerous and varied,
and are becoming increasingly important in the financial community.
6. What steps are taken in implementing a credit scoring process?
The major steps are careful planning, detailed design and controlled imple-
mentation. Discussion and agreement between the designers and users are
the key success factors in the process.
acceptance rates, p. 104 deregulation, p. 92 probability, p. 89

bad loans, p. 90 good loans, p. 90 ranking, p. 89
behavioural scoring judgemental decision- regression, p. 99
models, p. 96 making, p. 91 SMEs, p. 93
credit approval models, loan portfolio, p. 92 statistical, p. 89
p. 96 management information technology, p. 89
credit scoring, p. 89 systems, p. 96
Discussion
questions
1. What is statistical credit scoring? How does it differ from judgemental
methods?
2. Does the adoption of credit scoring add value to a financial institution?
What potential exists for an adverse outcome?
3. Credit scoring methods have mushroomed in recent years. What are
three applications of the differing methods? How do they add value to
the financial institution?

4. What are the main selection criteria that have been developed and
accepted as justification for credit scoring? Discuss these criteria.
5. What are the advantages and disadvantages of implementing credit
scoring within a financial institution?
6. Credit scoring developed in response to the need of financial insti-
tutions to be able to process an evergrowing number of applications
with everdecreasing resources. Discuss this development.
7. What are the two broad categories of credit scoring? How do they relate
to each other? Are they mutually exclusive and do they create tension
within the credit assessment structure?
8. Discuss the applicability ,of table 3.1 in the decision-making process for
implementing a culture of credit scoring within an organisation. Com-
pare and contrast judgemental and statistical methods.
9. Review the methods of statistical credit scoring and then discuss the
applicability by ranking them for the analysis of credit risk.
10. How would you implement a systems approach to the management of
credit risk within a financial institution without alienating the client
base?
References
andfurtherreading
Altman, E. I. 1989, 'Measuring corporate bond mortality and performance', Journal of
Finance, September, pp. 909-22.
Asquith, P. D., Mullins Jr, W. & Wolf, E. D. 1989, 'Original issue high yield bonds: aging
analysis of defaults, exchanges and calls', Journal of Finance, 44(4), pp. 923-53.
Caouette, J. B., Altman, E. I. & Narayanan, P. 1998, Managing Credit Risk: The Next
Great Financial Challenge, John Wiley & Sons, New York.
Capon, N. 1982, 'Credit scoring systems; a critical analysis', Journal of Marketing, 46,
pp.82-91.
Churchill, G. A., Nevin, J. R. & Watson, R. R. 1977, 'The role of credit scoring in the
loan decision', Credit World, March, pp. 6-10.
Durand, D. 1941, Risk Elements in Consumer Instalment Financing, National Bureau
of Economic Research, New York.
Fisher, R. A. 1936, 'The use of multiple measurement in taxonomic problems', Annual
Eugenics, 7, pp. 197-8.
Hecht-Neilson 1988, 'The theory of the back propagation neural network', Journal of
Neural Networks.
Hoyland, C. 1997, Data-driven Decisions for Consumer Lending - Credit Scoring
Techniques for Risk Management, Lafferty Publications, Dublin.
Myers, J. H. & Forgy, E. Q. 1963, 'The development of numerical credit evaluation
systems', Journal of American Statistics Association, 58, pp. 799-806.
Thomas, L. C. 2000, International Journal of Forecasting, p.16.
Thomas, L. C., Crook, J. N. & Edelman, D. B. 1992, Credit Scoring and Credit Control,
Oxford Press, Oxford.
Introduction
This chapter revisits and extends the basic lending concepts, financial analysis
and credit scoring techniques that you learned in earlier chapters. We will
introduce credit risk analysis. It is only in the past ten to fifteen years that
financial institutions have focused on credit risk. This is surprising because
loans have been provided since Biblical times. This chapter is important
because it addresses two issues:
1. What is credit risk? .
2. How do we analyse it?
To some extent, this chapter provides a cohesive harmonisation of the pre-
vious two chapters, because financial statement ratios and credit scoring models
have underpinned credit analysis, sometimes providing the basis for further
analysis. It is important to understand credit risk, however, before learning how
to analyse it.
Credit risk has been a vexed issue for many a lender. It has been the reason
for most insolvency of financial institutions in the past century. There has been
an explosion of analysis in the past fifteen years, with the development of many
tools. In this chapter, we will define credit risk and survey the principles of the
tools that analyse it.
Whatis creditrisk?
Credit risk and default risk tend to be terms that are used synonymously, but in
definition they have a slightly different focus. Credit risk is 'the risk of loss
through the default on financial obligations' (Galin 2001, p. 672) while default
risk is 'the risk that the issuer will not fulfil its financial obligations to the
investorlcreditor in accordance with the terms of the obligation' (Golin 2001,
p.675).
In the above terms, credit risk usually refers to the ability to repay a loan and
the magnitude of the potential loss. Default risk usually refers to the possibility
thai a repayment \\ ill he missed - that is, a default on the legal obligations. The
dilkrcllce hct\\cCIl the t\\O risks is minimal enough for us to interchange them
I(}1 I he purpoe.,c orth is text. \Ve \Nill use the following definition: credit/default
I/,!: i, IlIe PCliClltiuljeJlii1cjlllul1ciulobligations of a contract not to be fulfilled.
I hie.,definition docs not necessarily define lending or credit, but recognises
l rdii IIe.,ktlut alie.,csImm allY service that is provided and not paid for immedi-
This call mean an electricity bill as well as a loan or market-based loan
\ I,ll c\<1 lllpk. hunds, hank hills and commercial paper).
To define crcdit risk properly, there needs to be a contract, which must
ClIllllllg other functions):
• lIL-!1I1C the ohligations of the horrower
• ,klIl1C the ohligations of the lender
• lidilll' the payment elates for interest ane! principal
• indicate the maturity day.
/' -
There is a body of literature, beyond the scope of this text, that defines the
characteristics of a 'good' lending contract. In summary, the contract should
protect the interests of the lender without discouraging the performance of the
borrower. Our main interest is in whether the borrower makes payments in
accordance with the contract. There are three stages to this:
1. the credit risk analysis applied to the borrower's application for a loan (topic
of this chapter)
2. the assessment of the credit risk profile during the term of the loan (a topic
started in this chapter but expanded in chapter 11)
3. the credit risk profile when a loan becomes a problem (a topic discussed in
chapter 13).
Point 2 reminds us of a very important issue. It has long been assumed that
credit risk is static, but both academic and practical experience has shown that
credit risk can vary during the life of a loan. This phenomenon is known as
credit migration and can be best explained by a simple illustration.
If a bank extends a ten-year loan to a company, then it is unreasonable to
expect the company to remain the same over the term of the loan. If it is a good
company, then its credit risk profile will improve; if the company performs
badly, then its credit risk profile will deteriorate. It is important that these
changes are encapsulated over the term of the loan.
Howdoweanalysecreditrisk?
This chapter will survey credit risk analysis over the recent period. Keep in
mind that some of the tools discussed in this chapter are complex and some
financial institutions still use the most basic of tools. In other words, everyone
of these tools are still used in one form or another. The tools can be grouped
under the following four broad categories:
1. Expert systems are defined as essentially labour-based systems that depend
on human judgement. The main technique used is five Cs analysis (see
chapter 1) or a variant of this method (as in this chapter).
2. Some methods, called risk premium analysis, infer credit risk from financial
market-based premiums.
3. Econometrics are systems that use more and more extensive and complex
statistical methods. These methods include regression analysis and multi-
discriminant analysis. In particular, we will examine risk premium-based
and multidiscriminant models.
4. Hybrid systems build on financial theory and use these understandings to
predict credit risk. The best example is the method that is used by KMV
Corporation (see chapter 11, page 341).
Expertsystems
Expert systems are a misnomer, given that we should not infer that the methods
used under this heading are superior to other categories. In the overall context
I 110 ParI2 Analysisandinterpretationof creditrisk I

of lending, they are probably the worst performers. These systems are charac-
terised by the lending officer using predetermined credit criteria to make a
decision on a loan application.
The problem with this method, other than the obvious issues of time, is that
the performance of such systems is very uneven. The performance problem reflects
the experience of the lending officer and the application of the credit criteria.
The success and failure of expert systems relies on the experience and perfor-
mance of the lending officer. Many lending officers have the 'instincts' to make
good lending decisions and effectively analyse lending applications; many,
however, unfortunately do not have those instincts. In many instances,
decision-making processes are clouded by the lender's relationship with the bor-
rower. This is a reason for the rise of unambiguous statistical tools.
The issue of the lending criteria is somewhat bound up with the previous
point. Unless carefully written, credit criteria can be ambiguously interpreted as
the lending officer desires. Again, the lender's relationship with the client can
pollute the interpretation of the criteria.
It is also worth mentioning that these methods were developed before the
development of sophisticated computers and statistical tools. Many simple
lending organisations, such as small credit unions, nevertheless would still base
their decisions on such models, with limited support from other methods.
In summary, these systems tend to be manually based, with some computer
assistance for the calculation of simple financial ratios. In essence, the whole
procedure is based on paper, from credit application to approval and funding.
The following stages are an example of this process: "
• On receiving application from the prospective borrower, the lending
institution attaches a checklist to a file and follows the steps.
• The lender analyses and assesses each element of the checklist.
• The loan is granted or declined.
• In the event of loan approval, documentation is completed and the loan is
funded.
The most common procedure of this type is five Cs analysis.
ThefiveCs
As mentioned, financial institutions use a number of 'expert systems', of which
five Cs analysis (or derivations) is the most common. In essence, these systems
seek to cover the most basic of risk issues for the lender, including questions
such as whether the borrower is allowed to enter into the contract and whether
they have the means to pay back the loan under most circumstances. Expert
systems seek to set a framework that helps lenders ask the right questions. This
is the aim of five Cs analysis, which will now be examined in turn:
• character
• capacity
• cash
• collateral
• conditions.
Note that this discussion is different from that in earlier chapters. It is based
on Rose's (1993) derivation of the five Cs and is designed to highlight that there
are different approaches.
Character almost equates to the moral fibre of the borrower. Is the purpose of
the loan well defined? Does the potential borrower appear to be truthful in
answering the questions? This issue can be vexing if the borrower is new to the
financial institution and has no established track record.
Capacity is a legal question. Does the borrower have the legal capacity to
borrow? Court proceedings throughout the world have judged the position of
persons signing loan documentation. The following issues need to be con-
sidered here, depending on the loan.
• For retail loans, a minor cannot execute loan documentation.
• The situation for business loans is a little more difficult. A company
representative who has a title that appears to confer authority does not
necessarily have that authority. The position of 'manager', for example, has
caused problems in the past, as in a case relating to AWA Limited. For
business loans, it is suggested that the lending institution seek board minutes
on the delegation of financial management, to ensure management can sign
the binding documentation.
It is no surprise that the most important C is cash, because that is what
repays the loan. Much of the financial statements analysis in this chapter is con-
ducted to ensure the borrower can generate sufficient cashflow (as opposed to
accounting earnings) to repay the loan. The following ratios are used most
often:
Current assets
Current ratio =
Current liabilities
Net sales
Inventory turnover ratio =
Inventory
Net profit
Net profit-sales ratio = ----''--:-
Net sales
. . Debt
Deb t-eqUIty ratIO = --. -
EqUIty
The importance of cashflow should not be subordinated to collateral, which
can be considered only a secondary source of assurance of repayment. Whether
for a business requesting project funds or an individual needing a home loan,
the primary source of repayment should come from the project's earnings (as
opposed to the liquidation value of the project) or the individual's income
respectively.
This brings up the problematic matter of collateral. Collateral is the securing
of a loan with an underlying asset. The most common example of collateral is
the home from a home loan. Twenty years ago, banks often would rely on col-
lateral rather than cashflow as comfort that the loan would be repaid. Tight
financial conditions often produce difficulties in accessing collateral, however,

and liquidated assets are often sold at 'fire sale' prices. The most obvious reason
is that the sale purpose is known and the price is often bid down. In addition,
defaults on loans often occur in the recession period of the business cycle. In
this case, asset deflation acts with the previous reason to reduce the value of the
loan. The end result is that financial institutions record losses because the sale
of collateral does not cover the principal and interest outstanding. Except for
exceptional assets, such as residential property that is resilient to asset
deflation, financial institutions do not rely on collateral as much as they did
previously.
In developing the theme that many defaults occur during recessions, it is
useful to observe the process of the business cycle. In times of expansion,
demand for goods grows and many firms borrow to expand their business. At
the same time, interest rates tend to rise because the authorities tend to attempt
to dampen inflationary pressures that occur during this phase. Rising interest
rates place an obvious pressure on the cashflows of both businesses and con-
sumers. Demand falls, redUCing the cashflow of the borrower. If the borrower
did not account and plan for these risks, which is often the case, then default
may occur when cashflow falls to critical levels. Many lending institutions
know that this situation often occurs.
The final C is conditions - namely, the economic conditions under which
the borrower is operating. For a business borrower, conditions include the pros-
pects of the company, the industry and the economy in general. For an indi-
vidual, they include the stability of employment and income prospects.
Not all lending institutions adhere to this framework. Some financial insti-
tutions may choose to add other issues, such as the regulatory environment
(torturously called 'control' to fit the C nomenclature). More often than not,
however, the lender will reduce the number of categories rather than increase
them. At the very least, the lender would be expected to use character, capacity
and collateral.
Example
A local plumber approaches a lending institution for a loan to purchase a van
and tools for his business. He requests $15 000 and is prepared to offer the van
for collateral. The plumber is a current customer with the bank as an individual
and has occaSionally missed repayments on his credit card.
Over the past few years, the plumber has worked on and off for various large
companies. He requires these funds to start his own business. He rents his
accommodation and has moved many times over the past few years. He pro-
poses to set up his business in the area in which he is working. He has provided
a business plan of estimated income and expenditure. With the loan, the indi-
cation is that the business will have a growing annual surplus.
The plumber understands the difficulty he faces in obtaining a loan. He has
spoken to a retired uncle who is a self-funded retiree and is willing to act as a
guarantor for the business.
Using the five Cs, let us carry out a credit analysis on the plumber.
Solution
It is important to decompose the information on page 113 into the five Cs.
There may be some occasions when the same information is used for different
components. Further, note that this process may indicate the information that is
missing. The following analysis is not purported to be exhaustive; other deduc-
tions may be made.
Character There are a number of positive and negative points here. While the purpose of
the loan is well defined (the van and tools), some issues need defining.
• Why is a van required and not some other mode of transport?
• The tools are not specified. As a tradesman, does the plumber have any
existing tools? There is a common problem of borrowing for one purpose
and using the funds for another.
The other issue is the standing of the borrower. This would include the
standing of the guarantor as well, given that the uncle would repay the loan if
the plumber defaulted.
• It is a positive that the bank knows the plumber, but a concern that he has
missed payments on the credit card.
• It is the plumber's first business venture. There is no evidence that he can
manage a business. No name or telephone numberllocation for the business
has been provided. it may be deduced that he is employable, given that
large companies have previously used his services. References should be
obtained.
• The status of the uncle as a self-funded retiree may be deceiving. He will have
sizeable capital, but the availability of that capital needs to be examined.
A statement of financial position for the uncle should be obtained.
For both the plumber and uncle, the lending institution may consult a credit
reference agency.
Capacity The plumber, unless bankrupt, should be in a position to borrow.
Cash The business plan suggests that there will be a capacity to repay the loan. It has
been noted, however, that the plumber is inexperienced and the plan needs to
be questioned or adjusted. Most business plans present a very optimistic
forecast. It has already been mentioned that the statement of financial position
of the uncle needs to be obtained to ensure adequate capital is liquid.
Collateral No details are provided regarding the value of the van or the tools (although
they are not prOVidedas part of the collateral here). An important issue here is
that the plumber has not indicated how much equity he is putting into the
business or whether the loan is 100 per cent finanCing. Again, the financial
situation of the uncle needs to be assessed as a back-up.
Conditions The plumber would be working in the building industry, which is traditionally
volatile. It would be expected that the plumber would have little or no business
at times, which should be factored into the business plan.
The above analysis may seem overly pessimistic. The attractive parts of a pro-
posal should be highlighted, but it is when things go wrong that loans become
nonperforming. This is why negative issues are given prominence. Also note
that the five Cs should be used in conjunction with the financial statements
analysis discussed in chapter 2.

Before completing this section, we need to mention that there are other types of
expert system. A popular one in Australia is known as PARSER:
• Personal characteristics of the borrower
• Amount required and why
• Repayment capacity
• Security
• Expedience or future profitable opportunities
• Return from the loan.
While having many similarities to the five Cs, PARSER includes one impor-
tant issue forgotten in much lending literature: the return on the loan. In the
past, lending has been based on the creditworthiness of the applicant. This
focuses on only one side of the risk-reward paradigm often used in the finance
question: the risk. Too often, lenders have not focused on the reward for the
risk they are undertaking. In the future, models will need to recognise that any
credit risk assumed must be awarded with the appropriate return. Having said
this, the PARSER method generally does not give the appropriate methods for
determining reward.
Riskpremiumanalysis
Measuring credit risk by examining the risk premium is a simple and basic
method to use when considering corporate debt. In its Simplest form, the
approach may work for corporates that are rated by a credit rating agency.
CCredit ratings will be examined in chapter 12.) The approach is as follows.
Given that various credit rating agencies rate corporates, it should be possible
to measure the premium between each corporate credit rating and a risk-free
rate such as a government bond rate. This is known as the term structure of
credit risk. Those familiar with the term structure of interest rates will recog-
nise a lot of similarities.
The premium and probability of repayment can be calculated by comparing
the rate of a rated bond with the risk-free rate as follows:
pC1 + r) =1+ i
where
p = the probability of repayment
r = the interest rate on the corporate bond
i = the risk-free rate.
The probability of return, therefore, is:
l+i
p= l+r·
This formula is telling us that the financial market participants would be
indifferent about buying a risk-free bond (1 + i) or a corporate bond (1 + r), as
long as they were compensated for the possibility of d.efault.
The above relationship will hold when p ensures the analyst is indifferent
about investing in corporate debt and risk-free debt. The r represents the yield
on securities for a rated debt issue. An example shows how this operates. What
would be the probability of repayment and the premium if the government
bond rate was 6 per cent and AA rated bonds were trading at 9.0 per cent?
1+i
P= 1+ r
1 + 0.06
1 + 0.09
= 0.972
The debt has a 97.2 per cent chance of being repaid and a 2.S per cent
(100 - 97.2) probability of defaulting. The risk premium is 3 per cent
(9 per cent minus 6 per cent). Does this 3 per cent represent credit risk?
If it did, then one would need to question the use of more sophisticated
models when this simple analysis is available.
There are important issues here. The first would be recognised by those who
already have an exposure to the financial markets: it would be rare to find
bonds with a particular credit rating trading at the same interest rate. In the
example above, therefore, quite a number of AA rated bonds would be trading
at different premiums to the government bonds.
Does this mean that the credit rating is incorrect? No, it means that factors
other than credit risk also affect the premium. Financial market participants
often mention liquidity of a debt issue as being important for the premium. If
the debt issue is relatively small and difficult to trade, then a larger premium
may occur to compensate for the perceived lack of liquidity. It is difficult to
separate the pure credit risk from the premium.
JP Morgan has carried out much research in this area. It found that by split-
ting the market spread into credit risk and liquidity premium for credit rated
organisations:
• highly credit rated organisations overcompensate for liquidity
• from BB rated risk, there is an undercompensation for credit risk.
These findings should alert us to the dangers of using market spreads as a
credit analysis tool to assess risk.
The second issue is that the lender is assumed to receive nothing in the event
of default yet most lenders receive at least some reduced payout. Most financial
institutions have an estimate of returns in the event of default, based on the
type of loan (for example, secured or unsecured) and the term to maturity.
Using the above procedure of comparing against the risk-free rate:
[eO + r) x 0- p)] + [pO + r)] = 1 + i.
The new term in the above equation is e, which indicates what proportion of
the loan is recovered in the event of default. Most lending institutions have his-
torical data that indicate their experience of recoveries.
Using the previous example, where the probability of repayment was 97.2 per
cent, we can use debt recovery to work out a credit risk premium that would be

a measure of credit risk. The formula opposite (below) can be reworked to indi-
cate the premium that would be r - i, which is called pr in the following equation:
r= (l+i) -(1+0.
P (e+p-pe)
Assuming that the recovery rate on defaulted loans is 65 per cent, then the
answer to the previous example is:
r = (1 + i) - (1 +0
P (e+p-pe)
(l + 0.06) _ (1 + 0.06)
(0.65 + 0.972 - 0.972 x 0.65)
= 0.01.
The introduction of a recovery rate, whether it is security or other remedial

actions, shows that the risk reduces from 3 per cent to 1 per cent. While
security should not be a security blanket, it does reduce the credit risk. Most
financial institutions rely on two sources of information for their recovery rates:
• for rated debt, the ratings agencies
• for nonrated debt, the institution's historical experience.
It should be noted, however, that the actual recovery in the event of default
may be different from the estimated recovery provided by these sources.
Compounding the above issue, as well as being related to it, the analysis
does not account for the terms and conditions of the contract or consider the
collateral for the loan. For new loans, the analysis does not consider the
additional request for funds or the size of the loan relative to the statement of
financial position of the borrower. As we examine other methods, these issues
continually arise.
Riskpremiumsovertime
The above analysis has been defined, for simplicity, as a one-period loan. Given
that most loans extend beyond one period, we need to define the multi-period
loan. The repayment probability calculated earlier needs to be calculated for
each year. This is known as the marginal default probability. The probability of
default over time, which is known as the cumulative default probability, could
be calculated as follows:
Cumulative default probability = 1 - PI X P2X Pit
where
PI = the probability of default in period 1
P2= the probability of default in period 2
Pit = the probability of default in period n.
If the marginal probabilities of years 1 and 2 are 97 per cent and 95 per cent
respectively, what is the probability of default?
Cumulative default probability = 1 - (0.97 x 0.95) = 0.0785, or 7.85%.
An earlier section examined how to calculate the probability of repayment.
This is simple for the first year, but we do not necessarily have the default rates
for subsequent years, which are essentially based on forward interest rates.
There are a number of ways of calculating the forward rates, depending on your
belief in interest rate theory and the level of complexity required.
For the purpose of this discussion, assume the unbiased expectations theory:
that is, no arbitrage profits are expected from trades between maturities. This
implies an indifference about maturities and the forward rates can be inferred
from the spot rates.
At the simplest level, the average of two rates gives the forward rate. The
forward rate for one period is the average of the one and two period spot
rates. Assume, for example, that the one-year Commonwealth Government
rate is 6 per cent and the two-year rate is 7 per cent: what is the one-year rate
in one year's time? The following formulation can be used:
Oil + li 2
oi2 = 2
Re-arranging the equation provides the following answer:

1i2 = 2(oi 2) - Oil
= 2(0.07) - 0.06
= 0.08, or 8%.
where
Oil = the interest rate that starts today and matures in one period's time
o i2 = the interest rate that starts today and matures in two periods time
1 i2 = the interest rate that starts in one period's time and matures in two periods
time.
The interest rate 1i2 is needed to calculate the default rates for our example,
because we are seeking future period rates. The procedure infers the rates for
the future from current spot rates.
To be more accurate, the following geometric means can be used:
(1 + oi2) = (1 + Oi1)(1 + IiI)'
Using the example of the spot rates being 6 per cent and 7 per cent:
(1 + 0.07)2 = (1 + 0.06)(1 + IiI)

2
'1
11
= (l 1++0.07)
0.06
_ 1 = 8 .0001
/0.
The geometric and arithmetic means produce the same answers for this
example. The longer the time period under review, however, the more diver-
gence will occur. Market practitioners much prefer using geometric means.
The following example uses the same process for corporate rates and
then we calculate the marginal probabilities and, ultimately, the cumulative
probabilities.

Example
A credit analyst is seeking to determine the credit risk of a corporate over the
next two periods (assume zero recovery in the event of a default). The following
information is obtained:
One-year
rate(%) Two-year
rate(%)
Government bonds 7.0 8.0
Corporate bonds 9.0 10.5
Spread 2.0 2.5
The probability of default can be calculated from this information. Year 1 is

as follows:
1 + i1
PI = ""l+7
1
1 + 0.07
P = 1 + 0.09
P = 0.9816.
The next period's interest rates inferred by the yield curve can then be ascer-
tained using the one-year and two-year rates. The formula is as follows:
(1 + i2)2 = (1 + oi l )(1 + IiI)'
The result for the Commonwealth Government bonds would be:
(1 + 0.08)2 = (1 + 0.07)(1 + li 1)
2
li
l
= (1 + 0.08) - 1 = 9.00%.
1 + 0.07
The result for corporate bonds would be:
(1 + 0.105)2 = (l + 0.09)(1 + lil)
2
]/
'1 = (l + 0.0105) - 1 = 12 02°/
1 + 0.09 . 10.
The second period default probability is calculated as:
1 + i2
P2 = ""l+7
2
1 + 0.09
P=1+0.1202
P = 0.9730.
Recall that the default of this loan would be:
Cumulative default =1 - [P1P2]
= 1 - [0.9816 x 0.9730] = 0.0449, or 4.49%.
Econometric
analysis
Given the errors introduced by expert systems and the calculation vagaries
of using premium-based models, the introduction of sophisticated statistics
and econometrics gave credit analysis a scientific base from which to work.
Unfortunately, many of the models used lack a creditable theoretical basis.
This section is an overview of some of the methods. Some of the tech-
niques will be mentioned only briefly here because they will be examined
in chapter 14.
The analysis described here derives from two broad areas of statistics:
regression analysis and discriminant analysis. These have been refined in the
econometrics literature. Econometrics is the study of the mathematical relation-
ship between financial or economic variables.
Regression analysis and its variants describe the relationship between a vari-
able that is being examined - known as the dependent variable - and the
variables that influence it - known as the independent variables. The math-
ematical relationship is constructed in such a way that there is the least likeli-
hood of errors.
Discriminant analysis describes tJ1e differences between two populations. If
the two populations have characteristics that clearly discriminate between the
two, then using the variables that describe these characteristics, a function
can be developed to forecast the population to which a new entity would
belong.
ClassicalregreSSion
analysis
The simplest method to use is classical regression analysis, where a number of
factors are used to determine the creditworthiness of a borrower. If the analysis
is robust, then it provides a powerful tool for assessing whether a loan should
be provided. These tools can be split into two:
1. regression analysis
2. advanced regression analysis.
Each method has one common theme: that is, the characteristics of a good
borrower are radically different from those of a potential bad borrower. The task
becomes one of determining how to discriminate the characteristics of good
and potentially bad borrowers.
Regression analysis
The basic regression analysis is single variable regression, but this approach is
not suitable for lending decisions. As a starting point, therefore, we examine the
concept of multiple regression. The conclusions of multiple regression models
have a tendency to be unclear because the results can be open to interpretation.
The discussion here, therefore, will be brief, but the basis of the model gives
some clues on more useful methods.
Multiple regression seeks to use historical data to predict the future. There
are two types of data: the dependent variable that is to be predicted and the
independent or explanatory variables, which are used to explain the dependent

variable. In the analysis here, the dependent variable is the probability of
default, while the independent variables are variables that contribute to default
Cfor example, an applicant's home loan or a company's debt-equity ratio for a
business loan).
The major problem with this approach is defining the probability of the
default of existing borrowers. For many lending institutions, such data are
simply unavailable. The secondary problem, which exists for most econometric
techniques, is deciding which variables to include and which to exclude. Some
of the issues for the latter point become statistical in nature.
Given that there are significant issues with this method, we will move onto
more robust analysis.
Advanced regression
The linear probability model, or probit analysis, overcomes the serious
deficiency of the multiple regression model by defining the dependent variable
by two possibilities. Probit models seek to divide the samples into two; in this
instance, the dependent variable is divided into defaulted borrowers and those
that did not default. Using historical data, we can then regress this division
against those variables considered to be relevant.
Multiple regression would therefore analyse the problems as follows:
n
Pi = L f3iX i + error
i =1
where
Pi = the probability of default
f3= the estimate of the importance of variable Xi'
although with probit analysis
Pi = I if the loan has defaulted or
o if the loan has not defaulted.
The result for the probit analysiS should be between 0 and 1, reflecting a
probability of default. The analyst then determines the appropriate cut-off that
is acceptable for lending purposes. The other important issue is that this
analysis often gives predictions that are outside the appropriate range of 0-1.
Again, this introduces nonsensical answers.
To overcome this problem, we can transform the equation logistically as
follows:
fCp) = _I _
1+ e-Zi
The regression above would provide z.

If Pi is 0.5, then we would transform it through this function to ensure a
sensible answer.
Example
A bank has used considerable data to undertake logit analysis for lending. * It
has been found that the two most significant accounting ratios that provide an
indication of credit are liquidity ratios and earnings-assets ratios. A company
approaches the lending institution for a loan and has a liquidity ratio of 0.9 and
earnings-assets ratio of 2.
Solution
The function is found to be:
PI = 0.6(current assets + current liabilities) + 0.2(earnings + assets).
Substituting, we find that the probability of repayment is:
PI = 0.6 x 0.9 + 0.2 x 2
= 0.94.
In this instance, there is a high probability of repayment. The credit analyst
would need the management or board to indicate the acceptable level of
probability.
Discriminant
analysis
Perhaps the most significant advance in credit analysis came with the appli-
cation of discriminant analysis to financial distress. Initially developed by
Beaver (1966) but ultimately exploited by Altman (1968, 1993), this method
highlighted differences between two populations: the financially non-distressed
and the financially distressed. The technique came from the areas of psychology
and biology, where the characteristics of two populations were 'discriminated'.
The end result of the procedure is an equation that indicates whether a firm
is creditworthy. The equation, known as the Z score, is:
Z = 1.2X l + 1.4X 2 + 3.3X3 + 0.6X4 + 1.0X s
where
Xl = working capital divided by total assets
X2 = retained earnings divided by total assets
X3 = earnings before interest and taxes divided by total assets
X4 = the market value of equity divided by the book value of total liabilities
Xs = sales divided by total assets.
The Z score is a benchmark indicator that decides whether a company (as
opposed to a loan) belongs in the defaulting or nondefaulting category. In
Altman's formulation, a Z score greater than 2.99 meant that a firm is not in the
defaulting category and probably would be afforded a loan.
* Given the complexity of the logit analysis method. we will not show the procedures of estimation because
they are outside the scope of the texl. Texts on econometrics should be consulted if students have an
interest in this area. Further, most statistical packages carry out both probit and logit analysis.
I 122 Part 2: Analysisandinterpretationof creditrisk I

Example
A borrower provides a loan proposal to a lending institution. Credit analysis
determines the following ratios:
Xl = 0.4
X 2 = 0.7
X3 = 0.03
X4 = 0.3
Xs = 1.5.
Solution
Would the lending institution lend to such a company?
Z = 0.2 x 0.4) + (1.4 x 0.7) + (3.3 x 0.03) + (0.6 x 0.3) + 0.0 x 1.5)
= 3.239.
This score of 3.239 is obviously well over the 2.99 cut-off and, all factors
being even, a loan should be afforded.
Hybridsystems
The problem with many of the econometric solutions outlined above is that
they do not provide a sound theoretical basis for the analysis of credit risk.
They provide a statistical relationship between a number of variables and
default. This is adequate in many instances and the chosen variables are
common sense. As credit risk becomes an important issue, however, many insti-
tutions find these methods unacceptable. The concern is whether these models
will perform in a period of financial crisis.
A number of proposed new methods make use of financial theories. These
include expected default frequency and mortality models.
Expected
defaultfrequency
Lending, it is suggested, is about ensuring repayment. If the assets of a firm are
larger than the borrowings, then the owners will have an incentive to repay. If
the asset value falls below the borrowings, then the owners have no incentive to
repay. Under this framework, the lender needs to determine how far the value
of the assets need to fall before default occurs.
This framework will be examined in detail in chapter 13. It is based on the
thesis that the above relationship between borrower and lender is one of
options. Option theory, therefore, is applied to lending. KMV Corporation has
commercialised this framework.
Mortalitymodels
Mortality models are based on an insurance concept that a certain number of
people die in a particular year. Altman extended this insurance concept to esti-
mating how many loans 'die' or default in a year. This is called the marginal
mortality rate, at time t (MMR t ), which is defined as:
MMR = Total amount ofloans in a credit rating that defaults.
t Total amount of loans issued in that credit rating
The following issues need to be highlighted in this approach:
• The MMR is calculated for each credit rating and each year, so we would
expect the MMR to increase for each year.
• The MMR can be translated into a value by which the loan depreciates each
year.
The information that is required for this analysis is essentially historical (as it
is when used in the insurance industry). This approach can be criticised, there-
fore, for looking backwards rather than forwards. At this stage, this approach
has not had substantial testing and its usefulness in a credit crisis is unknown.
Puttingit all together

It is useful to look at an example that puts together the different analysis
approaches outlined in the earlier sections. A bank receives an application from
a retailing company that requires a $10 million loan to develop a shopping
centre store. The company is listed on the Australian Stock Exchange and is well
recognised and established. Any financial projections provided would be well
regarded. The company's credit rating is A and its bonds are trading at 7.5 per
cent, with the current appropriate Commonwealth Government bond rate being
5.9 per cent. The average share price for the period was $3.75.
As well as the financial projections, the following condensed financial infor-
mation is given. Full accounts would normally be available, but for simpliCity,
we have simply provided summary accounts here.
Total current assets $588015000
Total noncurrent assets $569749000
Total assets $1157764000
Total current liabilities $403930000
Total noncurrent liabilities $2{)3608000
Total liabilities $607438000

CC
Shareholders' equity $550326000
Retained earnings $278893000
Number of shares on issue 142869000
Profit before tax was $173897 000 on sales of $521 566 000, which con-
tinued the increased profitability of the company. As part of current assets,
inventory was $61 001 000.
As mentioned above, there are a number of ways of approaching this project.
Given the lack of technology available, we will not use all possible techniques.
I 124 Pari 2: Analysisandinterpretationof creditrisk

UsingthefiveCs
When using the five Cs, it is usual to also use financial statements analysis.
Character
The borrower, being a well-established company on the Australian Stock
Exchange, should give the bank some confidence. This listing is no guarantee,
however, that the company is doing well, as noted by recent collapses such as
HIH Insurance.
Given the size of the request, the bank would expect to have some track
record with the company and thus would examine that record. The fact that the
company is credit rated is also a positive.
The company also has a well-defined purpose for the borrowing, but the
bank should ensure the funds are used for the purposes proposed.
The management of the company is considered to be world class and its
strategy is considered to be good.
Capacity
A board minute approving the loan should be sighted. It should indicate
which company officers are authorised to negotiate terms and conditions for
the loan, and to sign the loan documentation.
Cash
While trusting the business plan presented, the bank would normally carry out
some type of financial statements analysis. Conducting selected ratios of
different types can provide assurance of the financial quality of the company.
Liquidity ratio (current ratio)
Current assets
Current ratio = Current liabilities
588015
=
403930
= 1.45.
This ratio is under the suggested benchmark of 1.5-2, as well as the retail
industry benchmark of 1.83. There may be good reasons for this low ratio. The
firm is expanding and this may be putting pressure on liquidity. Also, many
schemes are now used to attract buyers on easy credit terms. This situation
needs to be examined in detail.
Efficiency ratio (inventory turnover)
Inventory turnover = -Net- sales

- -
Inventory
521566000
61001000
= 8.56.
Conditions
For a company in the retail industry, the conditions would be the most diffi-
cult issue. For retail companies, their performance is very sensitive to interest
rates and the business cycles. During times of high interest rates, consumers
are reluctant to buy major retail items because the funds required would have
to be borrowed in most cases. In addition, the business cycle plays a major
role in spending decisions. Situations such as unemployment or threatened
unemployment will restrain the spending decisions of consumers. Having said
this, the company's profitability continues to grow and its strategies appear
sound.
As a summary, this analysis is reasonable with a well-known company. It
is based on the knowledge of the lender and past financial information. The
information is very company based. The bank could take the analysis one
step further and look at what the financial markets are saying about the
company.
Market-based
premiums
The company's debt is trading at 7.5 per cent compared with the comparable
risk-free rate of 5.9 per cent. Recall that the probability of repayment
(page 115) is:
1+i
P= 1 + r
1 + 0.059
= 1 + 0.075
= 0.9851, or 98.51%.
Whether 98.51 per cent, at a market-based premium of 1.6 per cent, is

acceptable depends on the risk appetite of the lending institution. As a
general indication, however, this would be a good credit risk. Further, the
above analysis is based on a zero return in the event of default and should
be modified for recovery. Assume that the lending institution has a recovery
rate of 90 per cent for A rated bonds. The premium would be adjusted,
therefore, to:
pr - (l + i) - (l + i)
(e+p-pe)
(1 + 0.059) _ (1 + 0.059)
(0.90 + 0.9851 - 0.9851 x 0.90)
= 0.001, or 0.10%.
Whether it is enough to rely on this premium is dubious, particularly when

the market is pricing a 1.6 per cent premium.
AltmanZ score
Recall that the Altman Z score is:
where
XI = working capital divided by total assets
X2 = retained earnings divided by total assets
X3 = earnings before interest and taxes divided by total assets
The bank would conduct the following calculations:

1. Working capital is the difference between current assets and current lia-
bilities, so Xl is 0.159.
2. X2 is 0.241.
3. X3 is 0.135.
4. X4 is 2.631, assuming that all the noncurrent liabilities are borrowings.
(Some may be provisions, which we will ignore for the purpose of this
analysis.)
5. Xs is 0.451.
Substituting into the equation, the bank can calculate the Z score as:
Z = 1.2X I + 1.4X2 + 3.3X3 + 0.6X 4 + LOX)
= 1.2 x 0.159 + 1.4 x 0.241 + 3.3 x 0.135 + 0.6 x 2.631 + 1 x 0.451
= 1.9527, which is below the benchmark but may be acceptable to some lenders.
In carrying out this analysis, the bank would come to one conclusion and
make an important observation. The conclusions that the three methods arrive
at are different: that is, the company may be creditworthy. It should be noted,
however, that most financial institutions would not use multiple methods. Fur-
ther, conflicting answers may occur when more than one method is used, given
the differing basis for each approach. Selecting an approach is important, with
significant testing required to ensure rigour for the types of loan being
proVided.
The observation is that none of the methods incorporate the amount into the
analysis. This is a common shortfall for many of the analysis approaches. Some
lenders incorporate the loan and changes to other variables (interest, profit and
so on) into financial statements to derive a more realistic picture. While this is
good practice, caution should be exercised. The credit analyst should ensure the
projections are creditable. Second, given that most projections are carried out
on an optimistic basis, some sensitivity analysis should be performed to observe
the results if projections are not achieved. Lending institutions often carry out
this analysis on a worst case scenario.

in the current vola-
In:::I18Se[!:> needing to pay more
according to a report
industry trend consolidation of core

accentuated by equity disparities between
seen some issuers become more predatory, while

stocks have become potential takeover tar-
does not factor this equity market volatility in

gearing levels" it says.
actions on Lend Lease, Boral and Email all reflect
two Standard &: Poor's reports that said merger and

prime reason for ratings changes in 1999.
on credit parameters '[It] takes on even
the outlook for certaiI1;::je6tors (e.g. banking, teleo!
generally for continued and acquisition] activity, and
..-nr'''''''o activities through asset. sales, as the demand for higher pIe
ratios rcrnn:t'JJnll,,,'
Salomons has called for improved documentation to protect bond holders
from heightened event risk and to.improve overall transparency.
Source: S. Aylmer 2000, 'Credit risk pricing needs a rethink Salomon', Australian Fimmd81
1 May, p. 38. .
Not everyone is in agreement on what should be included in credit risk analysis

models. This is obvious from the various analysis techniques outlined above,
which include many variables while leaving out others. The Salomon Smith
Barney comment in the above 'Industry insight' highlights one area that is often
missed by those who analyse credit risk: the context of the credit analysis.
Most credit analysis is developed with the implicit assumption that extra-
ordinary events do not occur. What if, however, there is an event occurring that
could affect credit risk? The scenarios that Saloman Smith Barney suggest alter
credit risk are takeovers and demands for higher shareholder returns. These risks
are known as 'event risks'. How are they incorporated into credit risk analysis?
The difficulty can be shown with a takeover. If borrowings are being used to
analyse a takeover, which entity is assessed? The acquirer, the target or the
potential nnv entity? A reasonable approach would be to assess eithrr the
acquirer or the new entity, hut on what basis could the new entity he assessed?
This issue has yet to be resolved in the development of models.
The issue is dealt with in the KMV model of expected default frequency.
where volatilities of organisation arc central. The issue remains undeveloped for
the combined entity, however. Future development of credit analysis will need
to account for event risk.
\Ve have considered the theoretical approach to assessing credit risk. but
what really happens) The 'Day in the life of .... below describes the actual pro-
cess of assessing credit. What arc the differences in practice!
Lending is a dynamic process. There is no standard procedure or formula for

evaluating a lending proposal, but each lender follows lending principles to
gUide the approval process. The most important step in the lending process is to
understand the credit risk of the new customer. This requires gathering and
evaluating information about the customer's business.
Determine the source of loan repayments and evaluate the financial health of
the business by analysing the financial statements of the customer.
Gain an understanding of the key risks to the customers ability to repay. by
assessing the customer's cash flows and business plans, and researching future
conditions for the industry in which the customer operates.
It is also necessary to confirm that the customer has the willingness to repay
the loan, by assessing the customer's husiness background. character and credit
history. This is most important if the customer's financial affairs come under
unexpected strain.
Detail the results of this credit risk assessment in a credit memorandum. This
is a record of the analysis of the proposal as \\cll as c\idence that the loan has
heen apprond hy an authorised officer of the bank and that it complies with
the financial institution's lending policy. The memorandum includes details
such as the purpose and structure of the loan. pricing and the hank's risk
grading of the cllstomer.
The new loan hecomes a legally binding agreement when the contract for the
loan is executed by both the lender and borrower. The contract includes details
such as the name of the borrowing entity, approval conditions or covenants, and
details of any security to be provided as collateral for the loan. The customer
can then draw down the loan funds vvithin the approved credit limit.
Continue to monitor the loan to ensure loan repayments are received on time
and in full, and covenants arc not breached. Also obtain and assess new infor-
mation ahout the customer, to take early action if the customer's credit risk
deteriorates during the term of the loan.
Summary
We have laid the groundwork for carrying out a simple credit analysis. While
basic in concept, the analysis would be suitable as a foundation for a more spe-
cialised analysis. The analysis also builds on the discussion in previous chap-
ters, particularly financial ratio analysis.
1. What is credit risk?
Credit risk is defined as the potential for the loan principal and interest to
not be paid in a timely manner. Credit and default risk are often defined
synonymously.
2. What are the various approaches to credit risk analysis?
There are a number of ways in which to analyse credit risk. These range from
simple expert systems that rely on human judgement to sophisticated stat-
istical methods such as regression analYSiS,discriminant analysis and hybrid
analysis systems.
3. What are expert systems?
While there are a number of expert systems, they all depend on human
analysis. They usually examine a number of core components of the attri-
butes of a borrower. Most financial institutions will create acronyms that
lending staff can remember and use when considering loan applications. The
most popular approach is the five Cs (or any of its variations). Another
approach is known as PARSER.
4. How is five Cs analysis conducted?
The most common expert system is five Cs analysis. This approach examines
the borrower under five headings: character, indicating the purposeful reason
for the loan; capacity, representing the legality of the borrower; cash, indi-
cating the ability of the borrower to generate the earnings to repay the loan;
collateral, as the security provided to support the loan; and conditions,
which are the economic context of the borrower. Financial statements
analysis is used to bolster this approach.
5. What do market-based spreads say about credit risk?
It is possible to derive the risk premium and probability of repayment by
comparing the corporate bond with risk-free bonds such as government
bonds. (Corporate bonds represent borrowings by companies with credit
ratings.) The probability is inferred when a lender is indifferent about
investing in corporate debt or government debt. Unfortunately, this risk pre-
mium is not solely credit risk. it can also include other risks such as the
liquidity of the corporate bond.
6. What are the various econometric approaches?
The econometric approach most commonly used is the Altman Z score, which
uses financial ratios and discriminant analysis. These approaches have prob-
lems with their theoretical rigour, which initiated research into hybrid systems.
7. How is Altman analysis conducted?
The Altman analysis is conducted by comparing the financial characteristics
of viable companies and distressed companies in a multidiscriminant model.
8. What are the hybrid systems of credit risk analysis?
Hybrid systems use known financial theories and apply them to lending.
Two hybrid systems were examined. The first was the expected default
frequency approach developed by KMV Corporation. This approach uses
some of the concepts developed in option theory. The second approach
was that developed in insurance theory, known as the mortality rates
model.
collateral, p. 111 expected default PARSER, p. 115

credit migration, p. 110 frequency, p. 123 probit analysis, p. 121
credit risk, p. 109 expert systems, p. 110 regression analysis,
cumulative default five Cs, p. 110 p.120
probability, p. 117 hybrid systems, p. 110 risk premium, p. 110
discriminant analysis, logit analysis, p. 122 term structure of interest
p.120 mortality, p. 123 rates, p. 115
econometrics, p. 110 multiple regression,
p. 120
Discussion
questions
1. Define credit risk.
2. What are expert systems? Outline the problems with relying on expert
systems.
3. What is the basis of using market-based risk premiums? Why do credit
analysts not use them more regularly?
4. How has the development of statistical tools helped credit analysts?
Explain why these tools cannot be the sole basis for decision-making.
S. Explain the basis of discriminant analysis for credit analysis and com-
pare it with hybrid systems of analysis.
The remaining questions are based on the folloWing proposal.
A financial services provider that provides computer software systems
approaches you. The company started off as a small private company and
has grown strongly over the past fifteen years and listed on the Australian
Stock Exchange. The company has businesses in many off-shore locations,
all of which are well-developed capital markets. In some parts of the world,
the company has near-monopoly markets.

As part of its strategy, the company uses acquisitions rather than growth
to continue to expand the business. While the business is software based, it
relies on continued activity in the financial markets. The company has had
the same management over the past fifteen years and the senior manage-
ment team are shareholders in the company.
The company is rated BBBand its bonds are trading at 3.3 per cent above
the comparable government bond rate, with the share price being $5.60.
Your bank's experience is that the recovery rate in the event of default is
50 per cent.
The condensed financial accounts are as follows:
Total current assets $66.3 million
Total noncurrent assets $659.9 million
Total assets $904 million
Total current liabilities $197.3 million
Total noncurrent liabilities $243.7 million
Total liabilities $473.0 million
Shareholders' funds $546.7 million
Retained earnings
Shares on issue 541614.
Earnings before interest and tax are $151 608000 on sales of

$742613 000. The firm is requesting a loan of $150 million to assist further
acquisitions.
6. Carry out a credit analysis on an expert basis.
7. Carry out a credit analysis on a market-premium basis.
8. Assuming the following function, make an assessment of the credit risk:
Z = 0.6 Debt - Equity.
9. Using the Altman Z score, what is the indication of credit risk?
10. Having carried out the above analysis, carefully outline the benefits and
disadvantages of lending to this company. What would be your final
decision?
References
andfurtherreading
Altman, I. 1968, 'Financial ratios, discriminant analysis and the prediction of corporate
bankruptcy', Journal of Finance, September, pp. 589-609.
Altman, I. 1993, Corporate Financial Distress and Bankruptcy, John Wiley & Sons,
New York.
Beaver, W. 1996, 'Financial ratios as predictors of failure', Journal of Accounting
Research (Supplement), pp. 71-111.
Caoeutte, J., Altman, E. & Narayanan, P. 1998, Managing Credit Risk, John Wiley &
Sons, Toronto.
Golin, J. 2001, Bank Credit Analysis Handbook, John Wiley & Sons, Singapore.
Hogan, w.,Avram, K., Brown, C., Ralston, D., Skully, M., Hempel, G. & Simonson, D.
2001, Management of Financial Institutions, John Wiley & Sons, Brisbane.
Rose, P. 1993, Commercial Bank Management, Richard D Irwin, Boston.
Saunders, A. 2000, Financial Institutions Management, McGraw-Hili, New York.
White, G., Sondhi, A. & Fried, D. 1998, The Analysis and Use of Financial Statements,
John Wiley & Sons, Toronto.

Introduction
Consumer credit generally refers to the loans that individuals or households
require to meet personal needs such as travel or the purchase of furniture,
household appliances, motor vehicles, boats or homes. Confusion nevertheless
prevails about what constitutes consumer credit. The Uniform Consumer Credit
Code, which is applicable to the whole of Australia and commenced operation
on 1 November 1996, defines the term widely: 'personal loans, bank term loans,
overdrafts facilities, housing loans, consumer leases and hire-purchase agree-
ments, are all covered. Mortgages, guarantees, and what are called closed-end
accounts are also included' (Weerasooriya 1998, p. 448). The Australian Bureau
of Statistics uses the term 'personal finance' instead of consumer credit, defining
personal finance as the finance provided to individuals for their personal, non-
business use. Both fixed loans and revolving credit finance are included in this
definition; secured housing finance and loans for investment purposes are
excluded (ABS 2002). The term consumer credit is not commonly used by the
Australian Bureau of Statistics, but could be understood to be the amount owing
on main credit card accounts in connection with the credit limit of main credit
card accounts (Fischer 6;[ Massey 1994). Weaver and Shanahan (1994, p. 125)
state that 'consumer finance is a broad term covering lending to personal rather
than business or corporate customers, for a wide variety of worthwhile pur-
poses'. They state that the most common forms of consumer lending are per-
sonal loans and credit cards. According to Fischer and Massey (1994, p. 4),
'consumer credits are loans to individuals for private, nonbusiness purposes
used to finance the purchase of consumer durables and services, including
motor vehicles, home improvements, daily life expenditures, travel expendi-
tures, and paying off other debts for private consumption, but excluding home
investments, such as the purchase of a residential property or financing the
repayment of a mortgage or a small part of the capital borrowed'. If you access
the websites of banks, you will find that banks include personal loans, credit
card loans, home loans and margin loans in the category of 'personal solutions'
or 'personal banking', as they call it.
We will define consumer loans as the types of loan made to finance consump-
tion and not for productive purposes; that is, these loans do not directly result
in increased production of goods and services as industrial or farm loans do.
The following discussion considers consumer loans in two broad categories:
personal loans and credit card loans. Home loans constitute a large proportion
of total loans of any financial institution, so it is appropriate to explain home
loans in a separate chapter (see chapter 6).
The maturities of consumer loans vary according to the purpose for which
the loans are given. These loans are generally given for periods of up to five
years (although home loans are given for much longer periods of up to
twenty-five or thirty years). Due to the rise in personal income and household
expenditure, the demand for consumer credit is rapidly growing. That demand
indicates consumers' confidence in the economy and is carefully watched by the
I
138 Part3: Consumerlending
government and central bank in any country. In its survey of consumer credit,
the Reserve Bank of Australia (1999, p. II) stated that 'continuing economic
expansion, with low inflation and low interest rates, has boosted confidence
among households, increasing their willingness to take on new debt'.
This chapter will introduce the special features of consumer lending. Con-
sumer lending is an important aspect of the overall loan portfolio of any bank,
so it is important for a lending banker to be familiar with the various issues
involved. The credit analysis of this loan type is much less complicated com-
pared with the credit analysis of, say, business loans.
Typesofconsumer
loan
After deregulation of the financial system in Australia and the consequent fierce
competition in the consumer loan market, banks have devised credit plans to
accommodate the financial needs of the consumers. There are several different
types of consumer loan. These loans can be classified by purpose, by the term
of the loan, by the terms of repayment or by security. If we consider pur-
pose-related categories, consumer loans include loans for the purchase of resi-
dential homes, investment properties, holidays, higher studies, household
furniture, cars, boats, shares and many other such purposes. If we categorise
consumer loans by the term of the loan, consumer loans include short-term
loans (loans generally for a period of up to one year), medium-term loans
(loans for a period of one to three years) and long-term loans (loans for a
period of more than three years). Yet another classification is by the mode of
repayment: instalment loans are short-term to medium-term loans that are
repayable in monthly or quarterly instalments, while non-instalment loans are
drawn by consumers to meet an emergency and generally are repaid in one
lump sum. The use of security is a further classification. When a loan is given
against a security of a property of the borrower, it is called a secured loan. In a
secured loan, the credit provider enjoys rights conferred by contract over the
property, which are exercisable in the event of the customer's default under the
credit contract (Duggan &: Lanyon 1999). When a loan is given without
obtaining security, it is called a clean loan or unsecured credit.
The above classification of loans is very useful. First, it helps banks to com-
pile statistics for making strategic loan decisions. The management of a bank
may find that loans for certain purposes - say, for financing holidays - are
growing. The bank can then study the factors that contributed to such a phen-
omenon and may continue with its strategy or modify it. Second, classification
can reveal the areas of lending in which the bank is overexposed. This will help
the bank in taking appropriate risk control measures. Third, if the bank finds
that certain types of loan are not picking up, then it may study the reasons and
devise attractive schemes. Additionally, regulatory authorities may require
banks to report their lending by purpose, so as to watch whether banks' loans
are concentrating in certain areas. The regulators can then issue timely warning
to the banks. The banks in Hong Kong and South Korea, for example, were
overexposing themselves to the financing of property loans, which led to sky-
rocketing property prices, mainly financed out of bank loans. The realisation
that the real value of the property was not really that high resulted in the col-
lapse of the property market, and the banks faced very high loan losses. A
proper watch by banks and regulatory authorities on the lending for various
purposes could have helped prevent this situation. In some countries, the
government may direct banks (as occurred in Australia before deregulation) to
lend a certain amount of money for specified purposes (for example, farm
loans). When loans are classified by purpose and statistics are collected accord-
ingly, the regulatory authorities can watch whether the directed amount of
credit is going to the required sector.
In the following sections, the discussion of consumer loans has been organ-
ised by the two broad types - that is, personal loans and credit card loans. (As
already indicated, home loans or real estate loans are considered in chapter 6.)
Personalloans
Households generally require personal loans for the purchase of items such as
furniture, home appliances, motor vehicles and boats. These loans may also be
taken to consolidate existing household debts. They are generally repayable in
monthly or quarterly instalments that extend over, say, two to five years and
carry a fixed rate of interest. In recent years, variable interest rate personal loans
have become more common. Some banks in the United States have set up
separate finance companies to handle these types of loan, because finance com-
panies can give riskier loans than those of banks, which may be restricted by
regulations. Personal loans can be negotiated with banks directly; that is, the
borrower visits the bank, submits a loan application and obtains a loan, which
he/she then uses for buying the desired asset. Alternatively, banks may indi-
rectly give these loans. A motor vehicle dealer, for example, may enter into an
agreement with the bank whereby the bank may provide finance to the dealer's
customers (called auto-finance). The dealer will obtain a loan application from
the customer, negotiate terms of the loan with that customer and then present
the application to the bank.
Personal loans could be instalment loans or non-instalment loans. In instal-
ment loans, the interest and principal are repaid in equal monthly or other such
instalments, as agreed by the bank and the customer. These loans could be
secured or unsecured. The security for an instalment loan is generally the asset
(say, a motor vehicle) purchased out of the loan. Unsecured instalment loans
are given to borrowers with a high credit standing who have been customers of
the bank for a long time.
Personal loans can be overdrafts or non-instalment loans. Overdrafts are also
known as revolving lines of credit. Overdraft literally means an overdrawing of
the account. The bank allows the customer to withdraw amounts larger than
the credit balance in the account. It will charge the customer interest on the
overdrawn amount. Banks generally prescribe a limit - say, $5000 or $10 000
- up to which a customer can overdraw the account. In non-instalment loans,
140 Part3: Consumerlending I

the entire loan is repayable in one lump sum or could be in the form of a
line-of-credit facility. Such loans are usually of a relatively small amount (say,
$500 to $2000) and repayable in a lump sum in a period of around one month.
These types of loan are often given to finance a holiday, to meet medical and
hospital care expenses or to pay for home repairs.
Margin lending is another type of personal lending. It is lending to con-
sumers or corporate or any other entity for share investments. When margin
loans are made to consumers, they are classified as consumer loans. Credit pro-
viders may lend individuals up to a certain percentage of the market value of
the shares. The ratio of the loan extended by the bank compared with the
market value of a stock is called the loan-to-value ratio (LVR). Banks normally
use an LVRof 40-70 per cent. When the market value of the shares is reduced,
banks may send a margin call to the consumer, so as to maintain the LVR. All
the major banks provide margin lending facilities (for example, see details
about the Commonwealth Bank's margin lending at www.comsec.com.au/
MarginLendingi) .
The following 'Industry insight' shows a method of financing practised in
regional Australia by traders to provide finance especially to Indigenous
Australians.
and Investments
Consumer Problems, a
of short-term credit that is

card and PIN number with
posted care of the store. It
consumers are mainly
book up can offer consumers benefits, in

when other sources are not available. However, the
by some traders results in a range of problems and
Segal said.
the use of book up in stores and it identified a
from poorly operated book up, including:
one retailer for all of their purchases
and poor recordkeeping, with mistakes made in the
(continued)
-. -
• excessive credit (maybe being] advanced, leading to a spiral of debt
• consumers having no, or limited, access to their funds, especially when
stores are dosed
• conSUmers having no opportunity to learn and practise electronic banking
and money management skills
• consumers exposing themselves to greater liability if an unauthorised trans-
action is made on their account.
However, there is a wide range of views held by the users of book up about
the desirability of retaining the practice in stores.
'ASIC will hold adialogue with people associated with book up to determine
the best way forward', Ms Segal said.
The report considered a number of options to improve how book up works,
including:
• improving the way book up is operated
• supporting consumer education and skill development
• improving access to relevant or alternative financial services
• addressing underlying causes such as poverty and financial literacy
• prohibiting or attempting to eliminate [the] retention of debit cards and
pilssbooks.
ASIC's first step will be to co-host a workshop in Alice Springs in April
with the Aboriginal and Torres Strait Islander Com:mission (ATSIC) and the
Australian Competition and Consumer Commission (ACCC).
The workshop will look at Indigenous consumer issues, including a session
on book up that will consider the options raised in ASIC's report. Representa-
tives of communities, stores, the fin.ancial services industry and other regulatory
agencies are expected to participate.
ASIC intends to prepare a kit for Indigenous communities on book
be designed to proVide communIty leaders and others with
them decide upon the approach to book up they wish to take in
nity. '';';0
ASIC will work with others to educate store owners about how to avoid the
worst of the problems associated with book up and informing them of legal
issues associated with the practice. We will also seek to communicate with the
Indigenous communities so that in ... cases where the law is broken
and the conduct falls within our j can take appropriate action.
Source: Australian Securities and Investments' 'Book up - not always consumers'
friend', Media release, 7 March 2002.
Creditcardloans
Credit cards are fast becoming popular as a means of meeting personal financial
needs. Although several banks and nonbank credit card companies issue credit
cards, two credit card companies stand out from the rest: MasterCard and Visa.
Most banks operate as franchises of these two companies. To become a part of

either group's network, a bank has to pay a lump sum membership fee and an
annual charge that is based on the number of the bank's customers that are
actively using the cards. The franchising arrangement is useful for a bank
because the bank's card is accepted at most retail outlets both in Australia and
overseas. Banks market the cards and solicit business, but have to display the
logo of MasterCard or Visa on the card.
Credit cards are generally linked to bank accounts of the customers, who are
required to pay only a fraction of their monthly bill to keep the card going. The
balance is treated as a loan on which an agreed interest rate is charged. The cus-
tomer can pay the entire amount due any time to save interest. This is different
from certain other types of loan where early repayment may be penalised.
Credit cards offer several advantages to the customer.
• Convenience. Credit card holders need not carry cash because a credit card
bearing a reputed brand name such as MasterCard is accepted at many retail
outlets nationally and even internationally. They can use their card to book
airline tickets, pay fees and charges at government offices, pay for the
groceries at the supermarket and buy books and clothes, for example.
• MOllthly swnmmj. Every month, the bank sends the card holder a monthly
summary of each transaction made on the credit card. A record of expenses
incurred is thus automatically available.
• Financial freedom. Card holders need pay only a stated minimum amount to
the bank at the end of a period. The entire balance due on the card need not
be paid. This set-up gives card holders the financial freedom to arrange their
financial affairs. The credit card holders determine the timing and amount to
be borrowed by using the card.
• No procedural hassles. Online application for a credit card is possible and
does not require elaborate information from the applicant. No documents
need to be produced and the entire application procedure is quick and
simple.
• Low credit card fees. Some banks in Australia issue credit cards to their
customers without any fees.
• Electronic banking device. Credit cards can be used at automatic teller
machines (ATMs) to deposit to, or withdraw from, existing transaction
accounts.
There are also advantages for the credit card issuer (a bank, for example).
• Higher risk-adjusted return than that from other types of loans. Lawrence
Ausubel's study of the credit card industry in the mid to late 1980s in the
United States showed that the average rate of return on equity for credit card
lending was 60-100 per cent, whereas the average rate of return on equity for
banks was only 20 per cent (Evans &: Schmalensee 1999). Card issuers
receive income from three sources: annual fees, interest on unpaid balances
after the lock-in period and the discount charged to merchants.
• Huge market. The market for credit cards is ever expanding and the
competition for a larger market share is fierce among credit card providers.
• Higher interest rates. While interest rates on other loans may fall, those on
credit cards may remain at the same level. The interest rates on home loans
in Australia showed a declining trend for some years, but those on credit
cards have remained unaffected. In April 2001, the standard variable interest
rate on home loans of one of the major Australian banks was 7.31 per cent,
while that on credit cards was 16 per cent. Credit cards signify a profitable
source of income for banks.
• Expanding services. Credit cards enable banks to expand their operations
nationwide without the need to open branches. A bank in Queensland can
lend to a customer in Western Australia by issuing a credit card to that
customer. Further, once the customer details are available on the bank's
database, these can be used to cross-sell other products such as mortgages or
insurance.
• Price-insensitive customers. It has been found in the United States that credit
card customers are insensitive to the price they pay using their credit card.
Customers believe that the periodic interest is too small to cause them to
forgo spending convenience.
According to Grady (1995), merchants who accept credit card payment
receive the following benefits:
• An increase in the number of customers. Many customers shop primarily with
credit cards and rarely make purchases using cash. Credit cards often
facilitate impulse buying by customers who cannot immediately access cash
to buy items.
• Prompt payment for credit sales. This helps retain an appropriate cashflow for
businesses.
• An increase in the number of prospects. Merchants can develop their mailing
list for promotional offers and announcements of new products and product
sales.
• Customer profiling. It is possible to profile the customers that are being
attracted which can help in advertising and marketing.
• Advantage over other merchants. Acceptance of credit cards can have
competitive implications where consumers prefer to use merchants who
accept credit card payments.
There is also a down side to issue of credit cards: the issuing bank has to bear
the risk of loss or fraud ariSing out of the credit card transaction. The United
States has witnessed much larger losses on credit cards than on other types of
loan. Consumers often spend more than what they can reasonably service out
of their income.
Howdoesthecreditcardwork?
There are four parties to a typical credit card transaction: the customer, the
card-issuing bank, the merchant and the merchant's local bank (also called the
acquirer). A typical information flow when a credit card is used in an electronic
payment transaction at the point-of-sale has been well explained by the Reserve
I 144 ParI3: Consumerlending I

Bank of Australia and the Australian Competition and Consumer Commission
(2000, p. 18) (see accompanying figure S.l):
The credit card is swiped through an electronic terminal on the merchant's
counter (1). The transaction and card holder details are routed to the merchant's
financial institution (the acquirer) (2). If the acquirer is also the issuer, the trans-
action can be authorised internally and the authorisation returned to the merchant
(5). If the issuer is another institution, the acquirer routes the transaction to that
issuer either bilaterally (3) or via a 'switch' facility provided by the credit card
scheme (3a). The issuer either authorises or declines the transaction and a mes-
sage is sent back to the acquirer, (4) or (4a), and onto the merchant (5). If the
transaction is authorised, the customer signs the voucher. The merchant checks
the signature against the credit card and, if all is in order, the transaction is com-
plete (6). When transactions are authorised on-line, as in this example, the card
holder's available credit limit is adjusted immediately, although posting to the card
holder's account can take one or two days.
(3a)
(4a) (4a)
Scheme switch
(4)
Issuer Acquirer
(3)
(1)
(2) tt (5)
Cardholder Merchant
(6)
FIGURE 5.1 The process of a credit card transaction
Source: Reserve Bank of Australia and Australian Competition and Consumer Commission 2000, Debit
and Credit Card Schemes in Australia: A Study of Interchange Fees and Access, Canberra, p. 18.
It must be understood that the merchant's bank charges the merchant for
paying against the vouchers deposited. This generally takes the form of dis-
counting: that is, if the merchant depOSits sales dockets with a total value of
$1000, then the merchant's bank will pay only $960, thus charging a 4 per cent
discount. The merchant is willing to pay this charge because acceptance of
credit cards increases sales. The card-issuing bank charges the acquirer bank a
fee (usually 1 -2 per cent) for handling the transaction. These fees that financial
institutions pay to one another are called interchange fees (Reserve Bank of
Australia and Australian Competition and Consumer Commission 2000). The
card-issuing bank also charges the customer (a) an annual fee for issuing a
credit card and (b) interest on the outstanding balance.
Having discussed the different types of consumer loan, we will now explain
how consumer loan applications are evaluated.
Evaluating
consumer
loanapplications
Here, we will present the general principles of credit assessment of consumer
loans, followed by a step-by-step approach used by one of the financial insti-
tutions in Australia.
Generalprinciples
Like all other evaluations of loans, the assessment of a consumer loan appli-
cation follows the three fundamental Cs of lending: character, capacity and
collateral (Bock 1994). Some authors (Weaver &: Kingsley 2001, for example)
add capital and conditions, and thus have the five Cs of lending. According to
Caouette, Altman and Narayanan (1998), the three Cs of lending are char-
acter, capacity and capital. 'Capital', however, is usually included under
'capacity to repay' and 'conditions' are usually included under 'collateral'.
According to Rose (1999), there are only two Cs: character and ability (or
capacity) to repay. In this chapter, for convenience, we will follow the three
Cs of character, capaCity and collateral, incorporating the other two Cs
(capital and conditions) therein.
Character
The character of the prospective borrower is the Single most important factor
that influences a lender's decision whether to approve or reject a loan. Char-
acter is the most important and, at the same time, the most difficult factor to
assess. As quoted by Weerasooriya (1998, p. 99), the famous American banker
Pierpoint Morgan told a Senate inquiry that 'the first thing that I look for is the
borrower's character'. (We include the full quote on page 6.) Nothing can be
more powerful than this statement to adequately emphasise the importance of
character in bank lending. Although assessment of character is a subjective
issue, the following factors can assist:
• Track record of the individual. If the intending borrower is already a customer
of the bank, then it is easy for the banker to assess the track record because
the borrower's complete financial history is available. The longer the
relationship, the better it is. If the borrower is a customer of another bank,
then bank verbals (opinions) are requested from that bank. Banks sometimes
also refer to credit reference agencies and make enquiries with the borrower's
friends and relatives. Before making such enquiries, the bank must obtain
written consent from the borrower to this effect, as required under the
Privacy Act 1988.
I 146 Part3: Consumerlending I

• Ability. The ability of the borrower can be judged from the formal education
that he/she possesses in the area of activity that he/she wishes to undertake.
In addition to a formal trade or other qualification, the borrower's experence
in the particular area of activity is also an important consideration. These
aspects become particularly important in the case of business loans.
• Purpose of loan. The third important factor to be studied is the purpose for
which the borrower wants finance. The lending banker must ensure that the
purpose is lawful, and is consistent with the loan policy of the bank.
• The integrity of the borrower. The client must have both the ability and
willingness to repay the loan. The ability to repay can be judged from the
capacity to repay, but willingness to repay is a question of character. The
borrower may have sufficient surplus to repay the loan but may still try to
avoid repayment of the loan in time. Borrowers often do not realise the
importance of timely repayment and are lax in making payments to the bank.
In the case of existing borrowers, their track record proves useful for forming
an opinion of this aspect of character. In case of new borrowers, the bank has
to be more circumspect.
• Spending habits. The borrower's spending habits are important. Some
borrowers are 'Big Spenders' - that is, they spend far beyond their capacity
to repay from their earnings. The likely result of such habits will be the
borrower defaulting on a loan sooner or later. The bank must take adequate
precaution at the time of granting the loan. Large outstanding balances on a
credit card, multiple debts and a lifestyle inconsistent with earnings are some
of the symptoms that give rise to suspicion. Borrowers who have a known
history of gambling need to be handled with more caution.
Capacityto repay
If satisfied that the purpose of the loan is genuine and if the character checks on
the prospective borrower are all encouraging, then the lender will start taking a
serious interest in the loan application. The lender can judge the repayment
capacity of the borrower in several ways.
• Net income. The first and foremost consideration is the level of net earnings
of the borrower. Net income is the income remaining after payment of all
expenses. The application form for consumer loans normally seeks details of
the sources of income and expenditure. Income includes income from
employment, receipts by way of dividends and so on. If the spouse of the
borrower is earning, then the spouse income needs to be taken into account.
Expenditure includes items such as rent, the living expenses of the family,
and repayment of any other debts.
• Deposit balances with the bank. Another way to check the creditworthiness of
the borrower is to check the average balance maintained in his/her accounts
with the bank.
• Stability ofjob. Job stability and continuity are other indicators of capacity to
repay. Borrowers that have contractual jobs need to be assessed with care.
• Stability of residence. This is another factor taken into account in personal
loans. It is generally believed that a borrower who has a stable residence has
a more stable personal situation. Home ownership is often viewed as solid
evidence of a stable financial situation. Having one's own telephone, house
and household furniture is an indicator of a stable financial position.
• margin. The larger the borrower's contribution relative to the
bank's contribution, the better it is. The borrower's margin is the borrower's
capital in the total investment.
Collateral
Collateral literally means 'along side'. Something that goes 'along side' the loan
is called collateral. In banking circles, the term 'collateral' is used as synony-
mous to 'security'. It is often said that a prudent banker never gives a loan
against security alone, which means that security should not be the prime con-
sideration in giving a loan. The main consideration should always be the via-
bility of the venture. This is especially true in the case of business loans. Loans
should be given if the borrower has capacity to repay. Collateral is something to
fall back on if the circumstances of the borrower change and he/she finds it
hard to repay the loan out of normal sources of income. Invoking collateral is
the last resort when all other means to secure repayment of the loan have failed.
It is a legal process that is both time consuming and expensive for the banker.
It may also create bad feeling between the borrower and the bank. If no avenues
are left to recover the loan, however, a banker should use the right to dispose of
the collateral and use the proceeds in repayment of the loan. Finally, general
economic conditions should also be taken into account. In recessions, financial
institutions may be less confident about lending.
The above principles guide all lending decisions. We will now present a
step-by-step approach that is generally followed while assessing a personal loan
(for example, a vehicle loan). This will help you grasp the essentials of evalu-
ating consumer loans. Many steps are common to all types of loan, although
some of the details may vary.
Step-by-step
assessment
ofpersonal
loans
The steps used in evaluating personal loans are discussed below.
Step1: obtaininga prescribed

application
form
Applications can be received by telephone or mail or at the branch. Applicants
must be residents of Australia and preferably are residents of the service area of
the branch. The lender should ensure the application is fully completed. In par-
ticular, the full name and address of all the borrowers, information about
employment of the borrowers (such as designation, contract term, salary, tax
and other deductions) and living expenses should be obtained. The lender also
should ensure to take authorisation for the disclosure of the applicant's infor-
mation to Baycorp Advantage/Credit Advantage (formerly the Credit Reference
Association of Australia). The authorisation should be signed by all applicants/
I 148 I
Part3: Consumerlending
guarantors. Dependents noted on the application must include children from a
previous relationship for whom the applicant pays child support. If the appli-
cant is not an existing customer of the bank, then it may be appropriate to open
a savings account first, after following the usual precautions. It is important to
obtain documentary evidence to support all the information given in the appli-
cation. In Australia, financial institutions mostly use the credit scoring models
(discussed in subsequent sections) where certain points (scores) are allotted for
each piece of information that the borrower provides. The sum of all these
points is compared with a cut-off score.
Step2: conducting
a preliminaryassessment
Credit Advantage should conduct a check on all applicants, including guaran-
tors. All information obtained and its source should be recorded in writing. The
bank official doing the credit check should sign and date the record. Check the
applicant's capacity to repay by calculating his/her net income. To calculate net
income, minus all deductions from gross income. The total commitments of the
applicant should not exceed 50 per cent of the applicant's net income. Total
commitments are equal to the repayment instalment of the loan applied plus
other commitments (such as payment of other loans). In the case of joint appli-
cants, the income of both applicants should be added. Allowances and overtime
payments should be added to income. Allowances on which tax is levied should
be added to gross income, while others should be added to net income. Income
from other sources could be added to gross income if received on a regular
basis. In the case of self-employed applicants, the lender should refer to their
tax returns for the previous two or three years or audited statements of financial
performance. Maintenance payments received by divorced persons are not to be
treated as income.
Proof of income - pay slips, group certificates, verification from employers
and so on - used in calculating the borrower's repayment capacity should be
held on file. An applicant's current employment, together with the term of cur-
rent employment, must be verified. If the current employment is for less than
two years, then the lender should make checks about the applicant's previous
employment. An employment check involves contacting employers or, in the
case of self-employed applicants, contacting accountants.
The address of the applicant can be verified by telephoning the landlord or
sighting rent receipts, mortgage documents, council rates notices, a house
insurance policy or confirmation from employers.
Step3: accepting
andloadingapplications
Applications that are accepted and loaded on the bank's computer system would
be given to customers for signing. An application can be cancelled anytime
before disbursement, but a letter to this effect must be obtained from the cus-
tomer and held on record. Customers also must be informed in writing. Even
where applications are not sanctioned, the reasons for rejection should be noted
in detail on the application. This is useful if there are subsequent complaints,
disputes or enquiries.
Step4: takingsecurities
Securities that will be taken for personal loans consist of one or more of the
following documents: a registered bill of sale over a motor vehicle, boat, caravan
and so on; a charge over banklbuilding society deposits (that is, term and savings
accounts); and a charge over the surrender value of a life insurance policy.
All vehicles secured by a registered bill of sale should have comprehensive
insurance registered in the name of the banklbuilding society as mortgagee. In
the case of vehicles purchased from a licensed dealer, details such as the full price
of the vehicle, the registration number, the engine number, the chassis number,
the make and model, the year of manufacture, the dealer's registration number,
the deposit paid and the amount ofloan should be recorded on the invoice. Where
vehicles are purchased privately, various searches should be conducted to estab-
lish title, nonencumbrance and, in some cases, bankruptcy. The vehicle should
be registered in the State where the banklbuilding society is located. The present
owners of the vehicle are required to sign a certificate that they are not bankrupt
and that the vehicle is not subject to any encumbrance. All vehicles used as
security should be registered with the State Motor Vehicle Securities Registry.
Boats are registered with the Department of Consumer Affairs Bill of Sale Registry.
The full cost of the vehicle is never financed. The borrower is required to con-
tribute a margin (that is, hislher own share) to the cost of the vehicle. In the case
of new vehicles, generally 80 per cent of the invoice price and, in the case of
used vehicles, 70 per cent of the invoice price or the price as per the dealer guide
(whichever is lower) is financed. Financial institutions generally insist that the
value of the vehicle should be at least $10 000. The norms of valuation in respect
of different types of vehicle are generally indicated in the loan manual of the
bank. The disbursement of the loan is generally made directly to the seller of the
vehicle. A bill of sale registration fee is also charged to the borrower's account.
Funds held in the account of the borrowers or guarantors may be frozen auto-
matically at the time of approval. This is known as the creation of a charge over
deposits. All the parties in whose name the deposit account stands are required
to sign such a charge. Banks sometimes obtain a charge over the surrender value
of the life insurance policy of the borrower. The surrender value should be ascer-
tained from the insurance company and 75 per cent of the value may be reckoned
as security. An assignment form and memorandum of transfer are completed and
registered with the insurance company.
A guarantee usually cannot be used for a personal loan, except perhaps where
security is falling short. The relationship between the borrower and guarantor
should be studied. The guarantor should be given full particulars of the loan con-
tract, which should not be altered without the knowledge of the guarantor. An
alternative to guarantee is co-borrowing. Here, the co-borrower's name appears
on all the loan documents and he/she signs all the documents.
Step5: determining
interest,feesandcharges
To calculate the interest to be charged on the loan, the lender deducts some per-
centage (for credit score concession and security) from the standard rate. The

fees and charges that are generally levied include: an application fee, loan con-
tract stamp duty, a bill of sale registration fee, an encumbrance search fee, a
bankruptcy search fee and a registered owner search fee.
Step6: approving/rejecting
applications
Applications are approved as per sanctioning powers given to managers
working at various levels of the bank. Where an application is rejected as a
result of the Credit Advantage report, the borrower may be advised accordingly.
In all other cases, the borrower may be advised that the application did not
meet the guidelines of the bank; there is no need to give any specific reason. If
a loan is approved, then at the time of disbursement, a senior officer should be
present to verify all the documents, ensure the borrower and guarantor sign in
his/her presence and certify that this has been done.
Step7: supervising
theloanandfollowingup
Personal loan accounts do not require much supervision, just a regular follow-up
to ensure the repayment of loan instalments are made in time. Reminder letters
may be sent to the borrowers whose instalments are in arrears. The first reminder
is generally sent within one week of the instalment falling in arrears, and a
second is sent a week later if the payment still has not been received. Every effort
should be made to assist borrowers who are in arrears. This could involve tem-
porarily extending the repayment period or accepting available payment now
and the remainder at the time of the next instalment. The credit/legal department
of the controllinglhead office generally takes legal action when the borrower fails
to pay despite follow-up. Where security is to be repossessed due to nonpayment
of dues, banks generally appoint a mercantile agent. Borrowers should be
informed in advance about the action and given sufficient time to bring the
goods to the bank themselves. If this warning fails, then the mercantile agent
may be asked to possess the goods and bring them to the yard of the bank. The
loans department reports loan defaults to Credit Advantage.
Step-by-step
assessment
ofcreditcardloans
The assessment of credit card loans is similar to that of personal loans. It is even
Simpler, involving fewer steps than those needed for personal loans.
• Step 1: obtain the duly filled-in prescribed credit card application form and
ensure all details have been completed. Applications can be received by
telephone or mail, over the Internet or at branches.
• Step 2: conduct credit checks via Credit Advantage, employers and from
other banks where the customer holds accounts.
• Step 3: if the checks are satisfactory, then load the details of the application
on the computer system. The computer system will automatically work out
the points and give a decision against a set cut-off as to whether the
application can be accepted or rejected.
• Step 4: where the application is approved, request that a credit card be made
ready, indicating the name of the card holder and the date to which the card
is valid. An approval letter and a detailed book of instructions about using the
credit card will be sent to the applicant. The card need not be sent directly to
the applicant, who instead may be advised that the credit card is ready for
collection at a local branch. The branch will hand over the credit card when
the applicant produces this letter and signs the card issue register. Where the
application is not approved, the applicant may be suitably advised.
Example
ofa consumer
loanapplication
Referring to the Commonwealth Bank's personal loan application form and
credit card loan application form as examples, we will explain how the infor-
mation sought on the forms ultimately helps the lending banker to assess the
quality of the loan proposal. We have tried to relate the questions on the appli-
cation forms to the three Cs of lending explained earlier.
Personal
loans
An application form for a personal loan is downloadable from the Common-
wealth Bank's website (www.commbank.com.au). It will help to have the form
handy while reading the following discussion.
Character
• On the loan application, the bank obtains the authority of the prospective
borrower to collect information from a credit reporting agency and to exchange
that information with other credit providers. Such an authority helps the bank
to carry out credit checks. The information that the bank will receive will throw
light on the character of the borrower. The bank may ask whether the applicant
has any other debts. Some applicants may not disclose this information, which
may not serve them well because the bank will come to know from other sources
whether there are prior debts. If an applicant hides information, the banker does
not form a good opinion about the applicant. In short, the applicant becomes
an 'at risk' party and the bank may not view himlher favourably.
• Some questions on the application form relate to the particulars and contact
details of the applicant. The bank will verify these details. Evidence that will
be used by the bank includes a driver's licence, proof of age card, a citizenship
certificate and an overseas or Australian passport. The bank can verify the
applicant's residential address by telephoning or visiting the residence. The
bank will also send letters to the residential address and request the client to
come to the bank with those letters. This confirms that the applicant is
actually residing at the address indicated. The bank also seeks the applicant's
length of residence at the address provided. Changing residence frequently
may not be viewed favourably by the bank. It shows that the applicant is not
stable at one place. As indicated in the discussion of credit scoring models
(see pages 155-8), a longer period of stay at a residence earns more points.
• One question on the loan application seeks details about the applicant's
previous employment. The banker may contact the previous employer to check
the applicant's character.
I 152 Part3: ConsumerlendingI

• The loan application contains a further question about character assessment.
From the status of an applicant's friends, a banker can obtain an idea of the
social strata to which the applicant belongs. Influential friends are a positive
in this assessment process.
Capacity
• Some questions on the loan application are about employment. The banker is
trying to assess the stability of the applicant's employment. If the employment
is stable, then there will be a stable source of income from which the bank
can expect repayment. The banker wants to ensure the prospective borrower
is able to service the debt (both the instalment and interest) on time. The bank
seeks the tenure of the applicant's employment. Casual or part-time employees
may not find favour with a banker. Again, the banker will also make inquiries
with employers about the status of the applicant's employment.
• Some questions on the loan application seek to assess the repayment capacity
of the applicant in one way or the other. The banker also seeks to know
whether the purpose for which the loan is sought is an approved purpose
under the bank's loan policy. Details such as the items to be purchased and
their prices are sought by the bank to know how the loan is going to be used.
The bank may also require a quotation.
• Some questions on the loan application seek information about the amount
the applicant wants to borrow and the approximate monthly repayment that
the applicant proposes to make. The amount that the applicant wants to
borrow reveals the applicant's own margin or contribution (recall the C of
capital). The bank will compare these details with the net income of the
applicant to judge whether the applicant can service the loan together with
interest. The bank asks whether the applicant is a new customer of the bank
or an existing customer. If the applicant is an existing customer, then the
bank probably already knows hislher financial dealings and has a good idea
about his/her character. If the applicant is new, then the bank will be more
circumspect. Some questions seek details about the income and expenditure
of the applicant, so as to arrive at the net surplus available to service the loan.
Collateral
The purpose of some questions on the loan application is to know the financial
standing or creditworthiness of the applicant. If the applicant has property and
investments, then the risk in giving a loan is much less. A further purpose is to
know what collateral (security) the applicant can offer. One question has a
similar purpose, requesting details of the applicant's friend/relative. The bank
can suggest that the friend/relative stand as a guarantee for the loan if needed.
Creditcardloans
An application form for a credit card is downloadable from the Commonwealth
Bank website (www.commbank.com.au).The information requested by the bank
is much the same as that requested on a personal loan application. This is
because the purpose of seeking the information is the same in both cases. Some
-
additional questions have been included, however, and here we will explain
why this information is required.
The relevance of some of the additional questions is obvious. The bank wants
to know the applicant's requirements of the credit card: that is, the type of card,
the interest-free purchase period required and whether the applicant is a
member of the bank's 'rewards' program. The interest rate that the bank will
charge on outstanding balances and the card fee will vary, depending on the
type of card option chosen by the applicant.
One question on the credit card application seeks information about the
applicant's residency status. If the applicant is not a permanent resident, then
the bank may be circumspect in issuing the card. It may be hard for the bank to
chase up credit card holders residing overseas if there are any outstanding dues.
Precautions
tobetakeningranting
consumer
loans
Consumer loans are far Simpler to assess and monitor than, say, corporate loans
or farm loans, but it is still important to take adequate care to avoid problems
down the track. A banker may face some of the following challenges:
1. Individuals may withhold information that is crucial to decision-making.
There could be issues relating to health or continuity of employment.
2. The applicant may provide inconsistent information. The inconsistencies
may be intentional or due to lack of knowledge of bank procedures.
3. Verifying some of the information provided could be a problem. On many
occasions, employers may not be willing to disclose details about their
employees to the bank. The banker also needs to be more cautious in dis-
closing information about a prospective or existing borrower. In the case of
Toumier v. National Provincial and Union Bank of England (1924), the
banker, in the absence of Mr Tournier, told Mr Tournier's employer of his
gambling habit and the state of his bank account. Mr Tournier's contract
was not renewed; he lost his job and successfully sued the bank for slander
and breach of confidentiality.
4. The applicant may have a good character otherwise but not realise the
importance of making repayments on the due date.
5. Individuals are susceptible to sickness, injury, loss of employment and
other such issues that may affect their ability to repay. Even family dis-
putes can affect the repayment performance of a borrower.
6. Individuals tend to overcommit through nondisclosure of other debt.
7. The individual must have a capacity to enter into a loan contract. A loan
contract, like any other contract, requires that the person should not be a
minor (less than IS years of age), someone of unsound mind or an insolvent.
S. The personal loan borrower should be encouraged to maintain a savings
account with the bank.
9. Borrowers must sign loan documents in the presence of an authorised bank
officer and preferably at the branch of the bank.
I 154 ParI3: ConsumerlendingI

10. Loans should normally be not given to repay an existing loan from another
source.
11. In the case of salaried borrowers, their salary should be credited by the
employers directly to a savings account with the bank.
12. If the terms of the loan are changed, then all the documents (including
guarantees) need to be re-executed.
13. Interest is calculated on a daily basis from the date of advance and debited
to the loan account on the last day of each month.
14. Many banks follow a credit scoring system for assessing personal loans.
The system serves as a guide, with approval decisions to be based on
income capacity, length of time in residence, length of time in employment,
association with the bank and previous credit history.
IS. In the case of fixed interest loans, if payment is received in advance, an
early repayment penalty applies. The penalty applies where the current
fixed interest rate is lower than the contracted fixed interest rate. The pen-
alty is equal to this difference.
16. The Privacy Act (Commonwealth Government legislation) applies to all
consumer loans. It requires that credit checks cannot be done without
written permission from the prospective borrowers. All parties to the loan
contract, including guarantors, have to sign the authorisation to carry out
credit checks. In case of applications over the telephone, verbal authority
should be obtained and then written authority should be taken before loan
approval and kept on record.
17. The bank is legally bound to give information relating to borrowers' accounts
to the Australian Taxation Office, the Department of Social Security (via
CentreLink) and the Public Trustee. In all other cases, no information can be
passed on to any third party without the express written authority of the
borrower.
18. A bankruptcy search is conducted through the Bankruptcy Registry in the
nearest capital city. An encumbrance search is conducted through the State
Motor Vehicles Security Registry, while a registered owner search is con-
ducted through the State Department of Transport.
19. The loan officer should carefully read the loan policy manual of the bank
and meticulously observe the procedures indicated therein, the docu-
mentation required and other such details.
20. The bank's head office advises the branches and offices of changes to the
loan policy from time to time. It is necessary to ensure loan officers are up
to date with all the changes.
Creditscoringconsumer
loanapplications
As already explained, banks assess the applicant's character, capacity to repay and
collateral before approving or rejecting an application. For credit assessment,
banks traditionally used judgemental procedures. As per these procedures, the
lending officer of the bank subjectively interpreted the information provided by
the applicant, keeping in view the bank's lending policy, and decided to accept
or reject a loan. Banks thus relied on the judgement of their officers, who were
usually given adequate training before they started as lending officers. Judge-
mental lending was not only subjective but also time consuming. The cost of
credit assessment was considerably high, given that the number of applications
one could assess in a day was limited. In more recent years, banks have developed
a more efficient and cost-effective system of assessment of consumer loans. Many
banks today use credit scoring to evaluate the consumer loan applications. The
major credit card companies such as MasterCard and Visa use the credit scoring
system to evaluate credit card applications. Similarly, a growing number of banks
and nonbanks are using credit scoring models to evaluate motor vehicles loans,
home loans and other types of consumer loan.
Credit scoring systems have many advantages over the judgemental systems,
• a large volume of credit applications can be handled
• applications can be processed speedily
• the operating cost of using credit scoring models is low compared with that
of judgemental models
• there is no need for elaborate training of loan officers, and training time and
costs can be saved
• customers like the convenience and speed with which applications are
processed and decisions are reached.
Many consumer loan applications can now be lodged over the Internet; for
example, the Commonwealth Bank of Australia and many other Australian
banks accept online consumer loan applications. The decisions regarding
approval or rejection are often given within a short time, either online or by
telephone, after the bank makes credit checks.
Credit scoring models are developed using statistical models (equations). In
these models, several variables are simultaneously used to arrive at a credit score
or ranking for each applicant. If the score exceeds the pre-determined cut-off
score, then the application is automatically approved. The variables that are used
in the credit scoring models include age, marital status, number of dependents,
home ownership, income bracket, credit rating, time in current employment,
number of bank accounts held, the type of accounts held and telephone owner-
ship. The credit scoring models attempt to segregate the good loans from bad
(risky) loans based on the past experience of the bank. The bank collects data
of loans that have proved to be sound and those that have proved to be risky
against each of the above parameters, then runs a statistical model (like a
regression or discriminant function) that gives the relative weights (points) for
each of the above variables. These weights are then used for constructing a credit
scoring model against which all applications are evaluated. The scoring models
are dynamic; that is, they are tested and re-tested periodically, and revised if
necessary. If a drastic change in any of the variables is found to influence the
model differently, then the model would be adjusted for that change.
I
The following table 5.1 shows the variables (factors) that are used in a typical
credit scoring model and the cut-off points for decision-making.
TABLE 5.1 Points value of factors in credit scoring models
Factorsfor predictingcreditquality Pointvalue
1. Customersoccupationor line of work

Professional or business executive 10
Skilled worker 8
Clerical worker 7
Student 5
Unskilled worker 4
Part-time employee 2.
2. Housingstatus
Owns home 6
Rents home or apartment 4
Lives with friend or relative 2
3. Creditrating
Excellent 10
Average 5
No record 2
Poor o
4. Lengthof time in currentjob
More than one year 5
One year or less 2
5. Length of time at currentaddress
More than one year 2.
One year or less 1
6. Telephonein phoneor apartment
Yes 2
No o
7. Number of dependantsreportedby customer
None 3
One 3
Two 4
Three 4
More than three 2
8. BtUtRaccountsheld
Both cheque and savings 4
Savings account only 3
Cheque account only 2
None o
Point score value or range Credit decision
28 points or less Reject application

29-30 points Extend credit up to $500
39--40points Extend credit up to $5000
Source: P. Rose 1999. Commercial Bank Management, Irwin McGraw-Hili, Boston, pp. 610-11.
Credit scoring models are not free from criticism. It has been said often that
lending is an art and there is no substitute for human judgement. Computerised
assessment of consumer loans can never replace human judgement. Credit
scoring models need frequent revisions because factors such as the conditions
of the economy and family lifestyles can quickly change. Unless these factors
are incorporated into the models, the models can do little to help the bank
make a sound credit decision. Failure of the computer system, virus attacks and
such other factors can adversely affect the operation of the online credit assess-
ment system.
8.30 a.m.
Arrive at the ollice. Have six personal loan and Visa applications that have not
yet been assessed. Check my diary and see four interviews booked in during the
day.
Look at the first application. Customer wants a \"isa card limit of 53000 lor
overseas holiday. Everything looks okay, so put in the 'to load' pile. The next is
another Visa application. A few concerns here. Only heen in her job IOllr
months and looks like just moved out of parcnts' home. Has no savings, is only
19 years old and already has another two credit cards. Do not like and \\'ill refer
to manager. Next is a personal loan application to purchasl' a nl"\ car. Cood
members and looks fine. Into the load file.
9.30 a.m.
Phone rings. A cllstomer has fOllnd the car he wants and wishes to proceed with
the personal loan that was approved last \\"Cek.. \sked for him to arrange il1\"oice
to he faxed so I can prepare documents. \\'anh the cheque this afternoon.
9.45 a.m.
Look at the remaining three applications. A personal loan for 55000 to buy fur-
niture. A young couple setting up home. Appears okay. Both have stahle
employment but little savings at the moment. Into the load file. :\ext one looks
okay but something is not quite right. Applicants have a numher of small con-
sumer dehts from various shops and other institutions and wish to refinance all
these into one loan. Six in all. They are both in their 50s and do not own a
home and yet they show they own a $25000 car with no corresponding debt.
I'll refer to manager. Final application is for an increase in Visa limit from
51000 to 53000. Previous conduct is vcry good; just need to verify income.
10.15 a.m.
Take the six applications into the manager to review. He agrees with my assess-
ments on the applications. Also has concerns over the final application but sug-
gests we obtain a credit reference.

10 .....5 a.m.
A customer calls forJle)." appointment. WisheSl0u.pdate her and requires
approximately $lOOOQ, is on a pension at the there is
little we can do. ..... . ; .. .. .
11.25 a.m.
Load the applications from this morning and order credit references. Surprise,
surprise. Our friends who wish to consolidate all their debts had an enquiry
only four months ago from a car finance company. I phone the company to
ascertain if there is any loan. Yes, there is, and it has been in arrears since day
one. I phone the applicant. He is quite nonplussed when I inform him that the
loan is declined due to nondisclosure of a debt, saying 'I didn't think you
needed to know about that one. It was worth a try'.
12.10 p.m.
A customer calls for her appointment. Is getting married in a few months and
wants a loan for a honeymoon. They have $10 000 in savings with us, but this
will be used on the wedding. Everything fine here and load application direct
while member is there.
1.00 p.m.
Just about to have some lunch. One of the cashiers has a person requesting a
credit card. I give her an application form, asking her to complete and drop
back with proof of income.
2.00 p.m.
Commence the employment checks on the loans we are to approve. Some
companies will not give out this information unless they have a written
request from the applicant. This happens on two of the loans. I contact the
applicants and request them to do this. Finally get the invoice for the car
loan. Customer is coming in at 3 p.m. to collect. Prepare the docs and have
countersigned.
2AO p.m.
A customer calls at the office unannounced. He has been off work now for a
month due to a broken leg. Complete an insurance claim form for loan repayment.
3.00 p.m.
Car loan customer collects docs. Explain where he needs to sign and have wit-
nessed by a third party. Next appointment also comes in, wanting to borrow
$15 000 to buy a 1984 car (a bit pricey for an old car). Only been working for
four months and does not have any bank accounts at all: 'Don't believe in them'.
Sorry, can't help.
(continued)
,-- -
3.30 p.m.
Finally complete all the employment checks and start preparing documents.
Phone the approved applicants and informed them the docs are ready for
collection.
4.00 p.m.
Last appointment arrives. A couple wish to borrow $6000 to purchase a car for
their son, who has just turned 18. I spoke to the son last week and told him we
could do nothing in his name, due to his casual employment being only six
weeks. Mum and dad agreed to get the loan and let him make the repayments.
Load application direct and should be okay.
4.30 p.m.
The cashiers hand me another two applications which members dropped in
during the day. Tidy up the files I have and leave at 5.00 p.m.
Source: Mr Ken Sloane, Manager, anonymous building society.
legal aspectsofconsumer
credit
Consumer lending activities of banks are subject to several laws and regu-
lations. The subject is so important that a separate chapter in this book
(chapter 7) deals with the legal aspects of lending. Here, we will look at those
laws and regulations that are particularly important in the area of consumer
lending.
TheUniformConsumer
CreditCode
The Uniform Consumer Credit Code has governed all new credit transactions
in Australia since 1 November 1996. The purpose of the code is to introduce
standardisation in all credit activities. It requires that credit providers present
credit information in a clear and easily understandable format. The code
applies to all credit providers, including banks, building societies, credit
unions, finance companies and businesses. It makes it obligatory on the part of
the credit provider to disclose all relevant information about the credit
arrangement in a written contract, including interest rates, fees, commissions
and other information. Prior to the code, some credit providers did not dis-
close important details, to the disadvantage of the consumers. The introduc-
tion of the code has enabled the establishment of user-friendly credit contracts.
It means that in case of sickness or loss of employment, a consumer can seek
modification of the contract so as to make repayments a lot easier. All the
types of loan that we study in chapters 5 and 6 - that is, personal loans,
credit cards and home loans - are covered by the code. Duggan and Lanyon
(1999) state that one of the main objectives of the new credit legislation is to
ensure transactions that are functionally similar are regulated in substantially
the same way.

Anti-discrimination
laws
Anti-discrimination legislation prevents credit being denied to anyone solely
because the applicant belongs to a different religion, sex, race, age or
nationality. The lending banker must keep in view, for example, the provisions
of the Sex Discrimination Act 1984.
TheCodeofBanking
Practice
The Australian Bankers Association published the Code of Banking Practice
in November 1993. The adoption of this code is voluntary, but most banks in
Australia have adopted it. The objectives of the code are to foster good
relations between banks and their customers, and to promote good banking
practice. The self-regulatory code, which is monitored by the Australian
Securities and Investments Commission, requires that the bank make certain
disclosures to customers. It sets out standards of disclosure and conduct
which subscribing banks agree to observe when dealing with their customers.
The standards cover matters such as terms and conditions of bank accounts,
the disclosure of fees and charges, privacy, confidentiality and how to resolve
disputes.
The Australian Bankers Association recently undertook to conduct an inde-
pendent review of the code, which is the first review of the code since its publi-
cation in November 1993. The review was undertaken to account for changes
in the banking services market and in the needs and behaviours of customers.
The final report of the review can be found at the website of the Australian
Bankers Association (www.bankers.asn.au).
Tradepractices
legislation
The Trade Practices Act 1974 regulates the conduct of business community, so as
to encourage fair dealing at all levels of business. Banks have to account for the
Act's provisions as far as those provisions relate to anti-competitive and decep-
tive trade practices. Weerasooriya (1998, p. 411) states:
... the [Act] is now used in litigations against banks as a substitute for, or in
addition to, the common law. The ... provisions that are commonly resorted to
are s.S2 relating to 'misleading and deceptive' conduct and s. SlAB relating to
'unconscionable' conduct. Banks loan transactions are challenged under these
provisions.
For details of the Act's provisions, please refer to chapter 7 on the legal
aspects of bank lending.
TheAustralian
Securities
andInvestments
Commission
The Australian Securities and Investments Commission (ASIC) Act 1989 empowers
the commission to monitor and promote market integrity and consumer protec-
tion in relation to the Australian financial system and payments system. The com-
mission regulates and enforces laws that promote honesty and fairness in
financial products and services, financial markets and Australian companies.
Privacylegislation
The Privacy Act 1988 (as amended in 1990) is an important Act that affects the
lending banker. It imposes limits on credit reporting agencies' disclosure of per-
sonal information. It specifies the circumstances in which the information can
be released. It also limits the use to which banks or other credit providers can
put personal information contained in credit reports. The consumer loans
application forms of banks invariably include a clause that authorises the bank
to obtain confidential credit information about the customer and also to
exchange that information. The activities that are regulated by this Act include:
• applications for credit
• the use of and access to credit reports
• the security of credit reports
• the reporting of defaults
• the refusal of credit
• debt collection
• the access of individuals to credit reports and dispute resolutions procedures.
Other than the above legislation, all bank lending is governed by laws and regu-
lations that include the Cheques and Payment Orders Act 1986, the Marriage Act
1961, the Native Title Act 1993, the Fair Trading Act 1992, the Property Law 1974
and so on (see Weerasooriya 1998 for details).
Trendsinconsumer
credit
Here, we will review some of the recent trends in consumer credit in Australia.
As already explained, consumer loans are one of the profitable avenues of
lending for banks and nonbanks. As people in general are becoming educated,
they are making use of bank credit to improve their standard of living. The
demand for consumer loans will thus continue to grow. It is so important that it
is used as one of the barometers of consumer confidence and the soundness of
the national economy.
The Reserve Bank of Australia (1999) noted that growth in personal credit in
Australia is due to innovation in products offered by banks, increasing house-
hold preference for the use of credit cards to make payments and, more
generally, continuing economic expansion, with low inflation and low interest
rates. Household debt has increased from about 50 per cent of annual house-
hold disposable income at the start of the 1990s to 90 per cent at present.
Other than growth in consumer lending, significant development is the
reduction in lending rates. The Reserve Bank (1999, p.11) noted that 'low
inflation and low interest rates have boosted confidence among households,
increaSing their willingness to take on new debt'.
The reduction in loan pricing has been mainly witnessed in the home loan
market, because the mortgage managers gained considerable market share in
the two years to June 1996. In recent years, banks have reacted to the compe-
tition by undertaking aggressive home loan marketing.

Trendsin personallending
The Australian Bureau of Statistics publication Lending Finance (cat. no.
5671 .0) contains statistics about personal finance in Australia. Table 5.2 shows
personal finance commitments in Australia by the type of lender.
TABLE 5.2 Personal finance commitments, by type of original lender
Credit Finance
Year All banks co-operatives companies Otherlenders Total Banks'share
(Juneend) ($ million) ($ million) ($ million) ($ million) ($ million) (%)
1997 2555 276 528 80 3439 74
1998 2816 300 641 122 3879 73
1999 3458 275 615 145 4492 77
2000 3784 277 683 201 4945 77
2001 4111 280 699 256 5346 77
2002 4339 292 713 246 5589 78

Source: Australian Bureau of Statistics 1999-2002, Lending Finance, cat. no. 5671.0, Canberra, table 2. Percent-
ages are calculated from data.
The above table shows that personal lending is on the rise and banks occupy
a dominant position in the provision of personal finance. The banks' share of
the personal finance market is also growing. Table 5.3 shows personal financial
commitments in Australia by purpose.
TABLE 5.3 Personal financial commitments, by original fixed loan facilities
Unsecured
Individual owner-
Totalmotor residential occupied Debt
Year vehicles blockof land housingfinance consolidation Refinancing Others Total
(Juneend) ($ million) ($ million) ($ million) ($ million) ($ million) ($ million) ($ million)
1996 717 78 51 154 310 394 1705

1997 788 112 57 178 344 443 1923
199.8 852 132 48 190 272 492 1987
1999 838 133 43 154 242 543 1952

2000 955 110 41 147 272 550 2075
2001 868 172 38 194 347 618 2237
2002 855 189 39 191 412 668 2343
Source: Australian Bureau of Statistics 1997-2002, Lending Finance, cat. no. 5671.0, Canberra, table 2 (1997) and
table 4 (1998-2002).
The above table shows that the major purposes for which personal finance is
issued in Australia are loans for motor vehicles and other loans (loans for boats,
caravans and trailers, household goods, travel and holidays, and so on).
Trendsin creditcardlending
The statistics for credit card lending have not been separately reported; the
Australian Bureau of Statistics reports the figures for revolving credit facilities,
which include credit cards. Revolving credit facilities generally have the
following features:
• A commitment for a credit or borrowing limit is given for a specific period,
after which the commitment is reviewed.
• The extent of the borrowing used at any time during the period may be for
any amount up to the authorised limit.
• Repayments (other than of charges and interest) made during the period
reduce the extent of the borrowing used and thereby increase the amount of
unused credit available up to the authorised limit. Examples include credit
cards, lines of credit and approved overdrafts.
Creditlimil at endof June
Totalavailable Percentageused
Year(Juneend) ($ million) Used($ million) (%)
1996 44418 18053 41
1997 51601 21358 41
1998 64279 28124 44
1999 80013 34683 43
2000 102805 46665 45
2001 115274 55582 48
2002 129536 60954 47
TABLE 5.4 Personal financial commitments, by original revolving credit facilities

Source: Extract from Australian Bureau of Statistics 1997-2002, Lending Finance, cat. no. 5671.0,
Canberra, table 3 (1997) and table 5 (1998-2002).
The above table shows the percentage of credit limit used is less than 50 per
cent. This means available credit far exceeds the actual need. The Reserve Bank
of Australia noted that recent growth in household borrowing has been concen-
trated in revolving lines of credit, which have grown at an annual rate of around
30 per cent. Earlier, fixed term (or instalment) loans were the mainstay of per-
sonal lending. The growth in revolving credit is attributed to the fact that it
offers more flexibility than that of instalment loans, having no maturity and no
fixed repayment schedule. The growth is mainly concentrated in three types of
revolving credit: personal overdrafts, credit cards and margin loans. In par-
ticular, as shown by figure 5.2, the debt outstanding on bank-issued credit cards
has significantly increased.
lendingI
164 Part3: Consumer
10
Outstanding debt
8 (Cards with interest-free period)
6
I:
g
:c
* 4
Outstanding debt
(Cards without interest-free period)
o
1994 1995 1996 1997 1998 1999
FIGURE 5.2 Growth of credit card lending in Australia (all banks)

Source: Reserve Bank of Australia 1999, 'Consumer credit and household finance', Reserve Bank of
Australia Bulletin, June, p. 13.
Credit cards occupy a dominant role in retail payment system. As per the
statistics provided by the Australian Payments Clearing Association and quoted
in a Reserve Bank of Australia and Australian Competition and Consumer
Commission (2000) study, 24 per cent of the number of noncash retail pay-
ments in May 2000 were made using credit cards, compared with 27 per cent
using cheques and 21 per cent using debit cards. The credit card market in
Australia is dominated by Visa, which in 1999-2000 held 51.4 per cent of the
market share of major cards and charge card brands issued. MasterCard (which
accounts for 22.7 per cent share) and Bankcard (19.2 per cent share) are the
next two major players in the credit card market in Australia. The Reserve
Bank of Australia and Australian Competition and Consumer Commission
(2000) also stated that the issuing of credit cards and the acquiring of credit
card transactions are highly concentrated in Australia. Around 85 per cent of
credit card transactions involve cards issued by the four major banks, which
are the same banks that account for 93 per cent of credit cards acquired.
A study by Visa International (2000) found that Australia is an ideal market
for both credit and debit card products. According to the study, the major driver
for credit cards is the penetration of nontraditional merchant categories (par-
ticularly bill payments), which account for 25 per cent of the transaction
volume.
The credit card schemes in Australia were under the review of the Reserve
Bank of Australia for some time. In August 2002, the bank released its final
reforms to credit card schemes in Australia. As per a Reserve Bank of Australia
media release on 27 August 2002, the reform measures involve the following:
• Interchange fees in credit card schemes will be decided by an objective,
transparent and cost-based benchmark. Interchange fees are the fees paid to
card-issuing financial institutions by the financial institutions that provide
services to merchants. These fees are thereafter passed on to merchants, who
in turn charge consumers the prices of goods and services.
• Restrictions that prevent merchants from recovering the costs of accepting
credit will be removed.
• Specialised credit card institutions that are authorised and supervised by the
Australian Prudential Regulation Authority can enter the credit card market.
The Reserve Bank of Australia believes these measures will help promote
genuine competition in the credit card market and reduce interchange fees by
about 40 per cent, which in turn will be reflected in the general level of prices
to consumers.
Theimpactoftechnology
In recent years, technology has affected many aspects of financial institution
management. The lending aspect is particularly suited to the use of technology.
Consumer lending has involved a growing use of technology. Financial insti-
tutions are using technology to sell consumer lending products and services,
receive loan applications, process loan applications, advise approvaVrejection,
and follow up and monitor loans. A customer can obtain all the information
needed to make a borrowing decision in the comfort of his/her home, either
over the telephone or online. The main impact of technology, however, has
been in the delivery of financial services to consumers. Technology has opened
up a range of alternative delivery channels, including telephone credit
approvals, mobile banking, sophisticated kiosks and Internet banking. It has
helped the development of new products by allowing wider access to redraw
facilities and equity access loans. Ulmer (1997, p. 17) stated that 'technology
has lowered the barriers of entry to financial markets generally and with respect
to credit products in particular'. The Wallis Report (1997) found that the
impact of technology is being felt particularly in three areas: retail payments
and financial service distribution channels; risk management and data assess-
ment; and the conduct of markets and exchanges. Present trends show that the
use of technology in banking, particularly in consumer lending, will continue
to grow.
Pricingandstructuring
ofconsumer
loans
An important part of a lending banker's job is to price and structure the loan.
Here, we will explain these tasks. (Please note that some aspects of loan pricing
and structuring also apply to real estate loans and may be repeated in chapter 6.)

Loanpricing
The pricing of a loan refers to the rate of interest, fees and other terms on which
a bank gives a loan. Several factors influence the pricing of loans, including the
sources of funds used for lending, the cost of financing the sources, risk con-
siderations in giving loans, the national economic growth rate, the rate of
inflation and the interest rates that competitors are charging. Most lenders are
financial intermediaries that procure funds from savers and lend to deficit units.
When the intermediary borrows funds from the savers (depositors, for
example), it has to pay interest. This is a financial cost of procuring funds and
is always factored into the pricing of all loans, including consumer loans. In
addition, a financial institution incurs administrative costs that it includes
when costing loan products. Lastly, there is a risk premium and profit margin
that need to be added. The price of a loan product therefore typically includes
the financial cost, the administration cost, the risk premium and the profit
margin.
Fixedandvariablerateconsumer
loans
Where fixed interest rates are charged, repayments are set for the duration of
the loan period, regardless of any movement in market interest rates. Some bor-
rowers find fixed interest rates easier for budgeting, because the loan repay-
ments do not change for an agreed period. A fixed rate loan involves an interest
rate risk for the lender, so the lender may charge a slightly higher interest rate
to cover this risk.
Banks also issue variable rate consumer loans. In this type of loan, the
interest rate varies as conditions change in the market. This means the repay-
ments may vary during the term of the loan. In a variable interest loan (known
as adjustable rate loan in the United States), the borrower shares the risk of a
fluctuating interest rate with the lender. These loans generally have no pre-
payment penalties. The bank fixes the interest rate by adding a mark-up (risk
premium) to the prime lending rate. If the prime lending rate is 10 per cent and
the mark-up is 3 per cent, then the variable interest rate will be 13 per cent. If
the prime lending rate moves up to 12 per cent, then the interest rate on the
consumer loan will automatically move to 15 per cent.
Leading newspapers routinely publish the interest rates charged by banks
on the various types of loan. The National Australia Bank website (WWw.
national.com.au), for example, showed on 20 April 2002 the following
interest rates for fully secured personal loans: variable rate of 7.97 per cent
and fixed rate of 10.52 per cent. For unsecured personal loans, the variable
and fixed interest rates vary, depending on the period and amount of the loan.
The National Australia Bank website showed credit card interest rates varying
from 14.35 per cent to 15.25 per cent, depending on the type of credit card
(accessed 20 April 2002). It is important to remember that interest rates keep
changing, depending on factors such as the demand for and supply of loans,
and the monetary policy decided by the Reserve Bank of Australia.
)' -
-
Bankfees
A further pricing aspect involves the levying of fees. The average borrower may
have little knowledge about the fees being levied by banks. There is growing
criticism of the exorbitant fees charged by banks. The banking industry is in
the public eye and has to be sensitive to the needs of the people. The fees vary
depending on the type of loan. In the case of the Commonwealth Bank of
Australia, the annual fee on a credit card loan varies from no fee to $100.
Loanstructuring
Besides pricing, a loan needs to be structured. Structuring refers to the repay-
ment patterns and other terms agreed between the bank and the borrower. A
bank loan officer usually works with the customer to select from different
pricing and loan structuring plans. The banker and the customer mutually
agree on the pricing and structuring of the loan before the bank makes a formal
offer of loan. While proposing the various options, the bank accounts for the
customer's other debt obligations and the loan amount that the customer can
reasonably service.
Two important elements of debt structuring are taking security for the loan
and deciding the loan covenants. The term 'security' refers to both the asset
against which a loan is given and also the documents (such as bonds, bills of
exchanges, promissory notes and share certificates) that establish ownership
and payment rights. There are a number of different types of security, each
having its own specialised documentation. An authorised bank officer must
duly sign, stamp and authenticate these documents. Documentation should be
completed at the branch, and loans should not be disbursed until all documents
are properly signed. Banks generally require the following information/docu-
ments with an application for personal loan:
• monthly earnings from wages, salaries and other (A wage or salary advice or
group certificate could help.)
• employer details, including name, telephone number and address, as per a
job appointment letter or other evidence
• details of any existing loans (such as personal loans, leasing and other
personal debts), as per a statement from the lending bank
• details of savings and investments, including account details, account
number and credit balances (If you are a customer of the bank, all
information will be available at that bank.)
• for renters, the landlord's name and telephone number and possibly a rent
receipt
• a list of assets, including investment properties, shares, car(s), furniture and
other assets, and their value
• a driver's licence number and possibly a photocopy of the licence.
At the time of actual disbursement of loan, the bank may ask borrowers to
execute or submit some or all of the following documents:
• a promissory note
• a letter of guarantee, which could be a personal guarantee

• the bill of sale (Hire purchase companies use this type of security when
lending for motor vehicles.)
• an assignment of shares or life policies, whereby the borrower gives an
irrevocable order that proceeds (if any) from life policies may be paid directly
to the lender (This is not always required.)
• a loan agreement form, setting out the terms and conditions of the loan.
The assets against which loans are given can be land and buildings, motor
vehicles, furniture, boats and so on.
Another important aspect in loan structuring is the finalisation of the terms
and conditions of loan. The loan covenants (terms and conditions) are decided
in consultation with the borrower. A loan agreement form usually includes the
follOWing covenants:
• repayment amount each fortnight/month/quarter
• interest rates (variable, fixed or variant)
• securitylinsurance (details of the assets to be mortgaged or insurance policy
to be assigned)
• a default clause, indicating actions to be taken in the case of default
• a prepayment clause (facilities for prepayment; penalties for prepayment)
• a schedule of fees and when these are payable
• stamp duty/government charges.
It must be remembered that the loan documentation is obtained at different
stages of the loan. At approval stage, the lender normally obtains written con-
sent as required under the Privacy Act, documents that identify the borrower
(such as a passport and driver's licence), Credit Advantage reports and valu-
ation certificates in case of home loans. Where guarantors are involved, par-
ticular care needs to be taken. Lenders may ask the guarantor to sign a letter
stating that he/she has obtained the services of an independent financial
advisor/solicitor and fully understands the extent of the responsibility involved.
A letter of offer of loan will be issued by the bank, and the borrower will
be asked to accept the terms and conditions mentioned in the letter. After
the loan offer is accepted by the borrower, other documentation is obtained.
The securities department of the bank generally ensures proper security has
been obtained. The duly signed security documents are then kept in the safe
custody of the bank.
Summary
1. What are consumer loans?
Consumer loans are loans given to individuals for the purchase of household
items such as furniture or an air-conditioner.
2. What are the three major types of consumer loan?
The three major types of consumer loan are personal loans, credit card loans
and home loans. (The volume of home loans in a bank's portfolio is so large
that some authors treat home loans separately.)
3. How are different types of consumer loan application evaluated?
Assessment of consumer loans is relatively simple and less complicated than
assessment of a business loan application. As in the case of all types of
lending, bankers rely on the five Cs of lending while assessing consumer loan
applications. For certain type of loans - for example, credit cards - banks
use a credit scoring system, which makes it possible to quickly evaluate
applications. A consumer loan application can be lodged over the telephone
or online, which makes it very convenient.
4. How are the principles of lending applied in practice?
In the loan applications discussed on pages 152-4, some questions are
about character assessment, some questions judge the capacity to repay as
well as capital, and some questions assess the applicant's creditworthiness
and available collateral. The lender is always familiar with external and
internal conditions, so the application forms have no questions on the C for
conditions.
5. What precautions need to be taken in assessing consumer loan applications?
Some of the major points to note are that: the information provided may be
incomplete or inconsistent; borrowers may not have the capacity to enter
into a contract; documents need to be signed before disbursement of a loan;
provisions of the Privacy Act, the Uniform Consumer Credit Code and other
relevant legislation need to be considered; and the proposed loan should
comply with the loan policy of the lending institution.
6. How is credit scoring of consumer loan applications undertaken?
In credit scoring models, several variables (such as age, income, equity in a
house and so on) are allocated points, which are added together to calculate
the applicant's credit score or ranking. If the score exceeds the pre-determined
cut-off score, then the application is automatically approved.
7. What laws and regulations affect consumer loans?
The major legislation that affects consumer loans is the Uniform Consumer
Credit Code, anti-discrimination laws, the Code of Banking Practice, the
Trade Practices Act, the ASIC Act and the Privacy Act.
8. What are the trends in consumer credit?
Personal lending is on the rise, and banks occupy a dominant position in the
provision of personal finance. The banks' share of the personal finance
market is also growing. The recent growth in household borrowing is con-
centrated in revolving lines of credit. A less than half use rate means available
credit far exceeds the actual need.
9. What is the pricing aspect of consumer loans?
Loan pricing involves interest and fees. Interest can be charged at a fixed rate
or variable rate, or a combination. Lenders charge various types of fees. The
fee income of banks, in particular, is growing.
170 Part3: Consumerlending'

acquirer, p. 144 discrimination, p. 161 margin call, p. 141
bankruptcy, p. 150 franchising, p. 143 margin lending, p. 141
collateral, p. 146 loan-to-value ratio (LVR), overdraft, p. 140
credit scoring, p. 149 p. 141 structuring, p. 168
Discussion
questions
1. What is consumer lending? What are its various types?
2. What factors have led to a rapid growth of consumer credit in Australia?
3. What are credit scoring models?
4. What are the important provisions of the Uniform Consumer Credit
Code?
5. Changing demographies in Australia are expected to have substantial
effects on a bank's consumer credit programs. Outline the changes
taking place in demographies in Australia and how these may have an
impact on consumer credit programs?
6. Majella Burke has applied for a loan of $10000 for furnishing her
house. She works as an assistant in a local travel agency. Her hus-
band Tony works as a mechanic at Kmart Tyres and Auto. Both have
worked in their respective jobs for about one year. They bought a
lO-year-old house a couple of months ago. They have a telephone
and a car. They also have some investments ($5700) with BT Funds
Management. Tony has a life insurance cover of $50 000 with a sur-
render value of $1500. The Burkes carry an average credit rating.
Using the credit scoring system presented in this chapter, decide
whether you will grant the loan if the bank fixes the cut-off points
for loan approval at 40.
7. The Bank of Toowoomba uses the following credit scoring system to
evaluate consumer loans of more than $5000. Applicants length of
employment in his/her present job: more than three years - 10 points;
one to three years - 6 points; less than one year - 2 points. Applicants
length of time at current address: more than three years - 10 points; one
to three years - 5 points; less than one year - 3 points. Applicants
current residence: home owner - 10 points; renting a unitlhome -
6 points; living with a friend/relative - 3 points. Credit Advantage
report: excellent - 10 points; average - 5 points; below average/no
record - 3 points. Deposit account with bank: yes - 5 points; no -
-
2 points. Active credit cards: one card - 5 points; two cards -
3 points; more than two cards - 2 points. The cut-off score fixed by
the bank is 30 points. Using this credit scoring system, evaluate the
following loan applications.
(a) Trent Delany holds a job as an instructor at a university, which
he has had for the past two years. He rents a house, for which he
pays a weekly rent of $175. The family has lived in this house
for the past eighteen months. He has a school-aged daughter,
Mary-Ann, who studies at the local public school. His wife, Sue,
does get some casual childcare jobs and earns about $500 per
month. The credit report is excellent. Trent and Sue each hold
one credit card, from two different issuers. They have invest-
ments of $3000 in Colonial First State. They have applied for a
loan to buy a new Toyota Corona priced at $22 000. What will
be your decision?
(b) James Hopley has asked for a loan of $7000 because he wants to
take his family to Las Vegas during the Christmas break. The loan
is intended to cover the airfares of James, his wife Carolyn and
his two children Gavin and Megan, and also the living and other
expenses in Las Vegas. James has an average credit rating, has
been in his current job for about two years, has been an
owner-occupier of his current house for the past two years, has a
telephone and an Award Saver account with the bank. Is his
request likely to be granted?
(c) Angela Rickard has run a convenience store for the past year. She is
separated, has two school-aged children, owns a car and owns a
house, where she has lived for the past four years. Her Credit
Advantage report is excellent. She has one credit card and is prompt
in making all payments before the due date, but she does not have
an account with the bank. Angela has sought a loan of $15000 for
renovating her house and buying a new air-conditioner. Examine
her request.
(d) Ron Robinson is a plumber. He has been employed by XYZ Civil
Engineers for the past six months. He has applied for a credit card.
He has a telephone and has lived at a rented house for the past four
months with his two friends. Credit Advantage has no record of
Ron, who also does not have a bank account. Will you approve the
application?
(e) Rachel Saul works in a coffee bar. She lives with her boyfriend,
owns a car and has a bank account. Her credit report is excellent.
She wants to buy a new Toyota Corolla and has approached the
bank for a loan of $30000. Her boyfriend works as a construction
supervisor and travels frequently. Examine her request.

References
andfurtherreading
AB S (Australian Bureau of Statistics) 2002, Lending Finance, cat. no. 5671.0,
Canberra.
Bock, C. 1994, Credit - Get it! How to Get the Credit You Deserve, Handle Debt
Wisely and Build a Secure Financial Future, Action Publishing, Monument,
Colorado.
Duggan, A. & Lanyon, E. 1999, Consumer Credit Law, Butterworths, Sydney.
Evans, D. S. & Schmalensee, R. 1999, Paying with Plastic: The Digital Revolution in
Buying and Borrowing, MIT Press, Cambridge, Massachusetts.
Fischer, W. C. & Massey, A. 1994, Consumer Credit in North Queensland, James
Cook University, Townsville.
Grady, B. 1995, Credit Card Marketing, John Wiley, New York.
Reserve Bank of Australia and Australian Competition and Consumer Commission
2000, Debit and Credit Card Schemes in Australia: A Study of Interchange Fees
and Access, Canberra.
Reserve Bank of Australia 1999, 'Consumer credit and household finances', Reserve
Bank of Australia Bulletin, June.
Rose, P. 1999, Commercial Bank Management, McGraw-Hili, Boston.
Ulmer, M. 1997, 'Managing credit risk: an overview', in Credit Risk in Banking, eds B.
Gray & C. Cassidy, Reserve Bank of Australia, Canberra.
Visa International 2000, Changing the Way We Pay: A Report on the Development of
the Payment Industry in the Asia-Pacific Region, Singapore.
Wallis Report 1997, Financial System Inquiry Final Report, AGPS, Canberra.
Weaver, P. M. & Kingsley, C. D. 2001, Banking and Lending Practice, Lawbook
Company, North Ryde, New South Wales.
Weaver, P. M. & Shanahan, K. M. 1994, Banking and Lending Practice, Serendip,
Sydney.
Weerasooriya, W. S. 1998, Bank Lending and Securities in Australia, Butterworths,
Sydney.
lending
you shouldbe to
loans
outlinetile trends in leal estatecredit
6. the of real estate1031lS.

Introduction
Loans that arc made for financing the purchase of a home or to fund improve-
ments to a private residential block come under the general category of home
loans. These loans are also called residential mortgage loans or real estate loans,
and are often made for longer periods of time, ranging from ten to thirty years.
They are secured by the mortgage of the property against which the loans are
made. Banks are the major providers of home loans in Australia. As indicated in
a later discussion on trends in home loans (see page 190), banks provide more
than 82 per cent of home loans in Australia. In recent years, however, the rise
of mortgage managers has challenged banks in this market. Even among the
banks, there is fierce competition to grab larger market share.
Home lending laggards St George Bank and the Commonwealth Bank of Australia
have picked up significant market share, mainly at the expense of ANZ Bank.
A market analysis by Deutsche Securities highlights the negative effect of ser-
vice problems within ANZ's broker-originated lending division.
In February - the latest for which data [are] availahle - ANTs rate of
lending growth almost halved, to 0.5 per cent, from 0.9 per cent in January and
from 1.4 per cent in December 2000.
In market share terms, ANZ had 12.4 per cent of the owner-occupied market in
the previous three months, compared with 17 per cent in the previous 12 months.
ANZ recently admitted that it was having trouble servicing its broker base,
!1"1 11i'.>lh Ill',,[lbe its popul<lr products
1 had created higher volumes than it
\.' I)
J, \ 1(1 !11, \l-[,! l'
\ '\./ \\CiC, ,dc,o caught out hy higher than expected mortgage demand in
i<l!lllcll"Y ;\l1d February - a period e:--:pectedto he a low season.
\ ! Dc U["l h.,' ligules ,,110\\ that St George's lending rose by 0.6 per cent in
! .,hi tun. douhle January'" (1 3 per cent.
\\hile <\tfly dayc" St C;Cl)rgc'C, m,lrkcrillg campaign and more competitively
priced products appear to be having an impact', Deutsche says in a report.
CEA, the nation's biggest home lender, has lost market share during the past
twelvemonths; The decline has been attributed to the bank's lack of exposure
to which now account for about 25 to 30 per cent of new
lending. .
CRA's new lending share was 15.1 per cent during the past three months,
compared with 11.2 per cent during the past twelve months.
In February, eBA's loan growth was 8 per cent annualised, 'consistent with
management's recent comments that approval levels had improved',
'We believe sustaining this volume growth will be critical as the bank ramps
up the integration of Colonial over the next six months', Deutsche says. The
Deutsche figures - based on Australian Prudential Regulation Authority sta-
tistics - also show improved market shares for Westpac and National Australia
Bank.
NAB's share was 17.2 per cent over three months compared with 15.4 per
cent over twelve months; Westpac's was 14.3 per cent compared with 11.6 per
cent on the same basis.
Source: T. Bareham 2()()1, 'S1George, CBA pull back ANZ in the mortgage race', The Australian,
9 April, p. 33.
Home loans are such a special class of consumer loans that some authors
exclude them from consumer finance. They require a reasonable under-
standing of property laws, mortgage underwriting practices, mortgage insur-
ance, financial analysis, property valuation principles, tax law, investment
analysis and the home loan market. Home loans can be broadly categorised
into loans for owner-occupied properties and loans for financing and
investing in income-producing properties. The distinction is important
hecause the repayment of these two types of home loan is expected to come
from different sources. Owner-occupied home loans are generally paid out of
the household income of the owners, while investment home loans are
generally repaid out of the rental income of the property. Accordingly, the
repayment capacity of an applicant is assessed differently in these two types
of loan. In this chapter, we will consider both owner-occupied home loans
and investment home loans. We exclude the loans for commercial property
because these are generally classified as business loans and are given to prop-
erty development companies. (Chapter 8 contains a discussion of commercial
lending.)
Secured housing finance is the largest single type of personal loan. This
form of advance has a number of distinct features, including longer
maturity, repayments in equal monthly instalments, low risk compared with
that of other types of consumer loan (because the property is collatera1), a
well-established system of financing, and high income from fees. Home
lending is a lucrative portfolio for banks. The risk of loan losses is much
less than that of business loans. Further, banks are required to hold less risk
capital (50 per cent) for home loans compared with business loans (100 per
cent). This has a favourable impact on bank profitability. The importance of
home finance in Australia can be gauged from the Commonwealth Govern-
ment's introduction of a grant (initially $14 000 to December 2001, then
$10 000 to June 2002 and soon to be phased out) to new home buyers, so as
to boost the housing sector. Government and industry closely watch the
statistics of new home loan approvals, which are an indicator of the strength
of the economy.

Evaluating
realestateloanapplications
Before learning how to assess home loans, it is important to be familiar with
some basic terms used in home lending.
Homeloanbasics
Here, we will explain the fundamental concepts without the legal details (see
chapter 7 for a discussion of the legal aspects).
Property
Property means anything that is owned or controlled. It could be real property,
such as land and buildings, or personal property (called chattels), such as furni-
ture, clothing and jewellery. Real property is immovable and personal property
is movable.
Realestate
Real estate is described as the earth, the land and all natural and human-made
hereditaments found permanently attached (Sirota 1994). Hereditaments are
things capable of being inherited. Land, streams, trees, minerals, buildings,
fences and other features permanently in place on the land are interpreted as
real estate.
Interestin realestate
There are two types of interest (a bundle of rights) that one can hold in a prop-
erty: a freehold interest or a leasehold interest. An interest that has no time
limit (that is, permanent in nature) is called a freehold interest in the property.
An interest that is held for a limited or fixed length of time is called a leasehold
interest. The freehold interest in property can be of various types. Fee simple
interest is the highest bundle of rights that a person may enjoy in real property.
Joint tenancy is another type of freehold interest, meaning that any number of
partners can own an equal and undivided interest in the property. This owner-
ship type is generally limited to family members and, upon the death of one of
the partners, hislher interest is automatically divided equally among the sur-
viving partners. Tenancy in common is another type of freehold interest,
meaning that many partners can hold an undivided but not necessarily equal
share of the interest in the property. Joint tenancy must be similar in every
respect while tenancy in common need not be so. When a tenant in common
dies, his/her interest can be transferred to another person by will; when a joint
tenant dies, his/her interest ceases.
In leasehold property, the landlord gives up possession of real estate to a
tenant who acquires an eqUitable interest in the property according to the terms
and conditions of the lease. The ownership of the property remains with the
landlord (lessor), who transfers to the tenant (lessee) only the right to possess
and use the property for a limited period of time. A common example is a rented
apartment, where the landlord is a lessor and the tenant is a lessee. The tenant
can use the property but not sell it, because the property belongs to the lessor.
Encumbrances
andliens
An encumbrance is a right or interest in a property held by one who is not the
legal owner of the property. Almost every parcel of real property has some form
of physical encumbrance imposed on it. Common examples are the utility
encumbrances for the installation of water, gas, electricity and telephone ser-
vices. These physical encumbrances are attached to the property and become
'covenants' that run with the land. Where the encumbrance is financial, it is
called a lien. 'A lien is a legal claim against a specific property, whereby the
property is made the security for the performance of some act, usually the
repayment of a debt' (Sirota 1994, p. 51). A mortgage is an example of financial
encumbrance.
Promissory
noteandmortgage
In real estate finance, the borrower signs a promissory note, which is a promise
to pay a debt and specifies the terms and conditions of repayment. A mortgage
is a pledge of real estate as collateral to secure the promise made in the
promissory note. The lender obtains the note whenever any loan is made
because it is a legal evidence of debt. A mortgage is a separate instrument but,
to be legally enforceable, has to be backed by a note. A mortgage creates an
enforceable lien against the collateral. A specimen of a promissory note and a
mortgage deed can be found in Sirota (1994).
Titledeeds
Title is an abstract term that refers to documents, records or acts that confer
ownership of property. When purchasing real estate, buyers must be in a
position to assess the quantity and quality of the ownership rights that they
are acquiring. The banker and the borrower will be interested in the assur-
ance of title of the real estate. Title assurance refers to the means by which
buyers of real estate (1) learn in advance whether their sellers have and can
convey the quality of title they claim to possess and (2) receive compen-
sation if the title, after transfer, turns out not to be as represented. Title is
usually conveyed from one person to another by means of a written instru-
ment called a deed. There are five different types of title to property:
common law title, Torrens title (which is the most common title), company
title, strata title and community title. (For details of each of these titles,
please refer to Weerasooriya 1998.) Some titles of ownership are more
expensive than others because the conveyancing and legal costs are different.
Some titles are restrictive and may not permit owners to do all that they
plan to do with the property.
Publicrecords
Procedures are in place to place the interest in real estate on public record.
Once an instrument creating a claim on the interest in real estate has been duly
recorded, the recording is deemed to give a constructive notice of interest to the
world.
I 178 Parl3: Consumerlending I

Valuationof property
The market value of the property against which the loan is being considered
needs to be estimated and has to be adequate to payout the loan in the event of
default in repayment. Valuation of property helps in calculating the
loan-to-value ratio (LVR). Lenders generally expect LVR of 80 per cent or
higher. This means that if the property is valued at $200000, then the lender
will advance no more than 80 per cent of this value ($160000) as a home loan.
The balance has to come from the borrower's own funds. Where the borrower
contributes less than 20 per cent of funds, the lender considers the home loan
'risky' and would insist that the borrower take out mortgage insurance. Mort-
gage insurance protects the lender (that is, it insures the amount lent), but the
borrower pays the insurance premium.
The value of the property is estimated by approved valuers (firms of archi-
tects or civil engineers), particularly if it is a commercial property, or by the
staff of the bank. The market value of the property may be different from the
price that the applicant is willing to pay. Market value is the price that the bank
can reasonably expect if the property must be sold in satisfaction of the debt.
The market value of any property depends on the factors of demand and supply.
According to Brueggeman and Fisher (1993), the demand-side factors include
the national, regional and local economic conditions, such as income, popu-
lation, employment and interest rates. The supply-side factors are the relative
cost of land and the factors of production, such as wages and capital. The valuer
considers current market equilibrium conditions by examining the availability
of housing units, absorption rates, rental vacancies and rent trends to gauge the
likelihood of any short-run price movements that may influence the estimated
value. Finally, the valuer examines the submarket - that is, the neighbourhood
and proximity to retail shops, schools, religious facilities, hospitals and so on -
in deciding the premium to be placed on the property.
According to Brueggeman and Fisher (1993), the following three approaches
are generally used for valuation of property:
• the market value approach
• the cost approach
• the income capitalisation approach.
New approaches have come into practice in recent years (see Wakefield
2000). We will restrict our discussion here, however, to the above traditional
approaches only, because they are most commonly used in Australia.
Themarketvalueapproach
The market value of the property is determined on the basis of values of similar
properties that have been sold in recent time. According to Rost and Collins
(1993), this method is used in cases where sale and subject lands are suffiCiently
alike and easily compared. This method is used more widely for determining the
value of bare land than of improved land. It is an efficient method in property
markets that are very active (that is, where frequent sales are taking place)
because recent and valid data are available without difficulty. It compares the
recent sales data on an equal basis, attempting to match size, location and quality.
In deciding the market value of house number 59 Jennifer Crescent,
Toowoomba, the yaluer would ask property dealers about the market value of
properties that were sold recently in that area and that are similar to number 59.
The \"aluer would then place a suitable value on this property. The values of
houses that are most recently sold and most comparable to the property in ques-
tion act as a guide in deciding the market value of the property. Adjustments are
made for features that are absent or additional in the property in question com-
pared \vith the other properties. The assumption is that a buyer would be prepared
to pay the same price as that of comparable property at that location.
This approach has several advantages. First, the valuation closely resembles
the true value of the property. Second, it is easy to determine the price because
prices of recently sold properties in the area are readily available from property
dealers (for example, www.allhomes.com.au). Third. there is no need to estimate
the value of each separate part of the property because the yalue is determined
for the whole property; it may be hard to find value for each of the property's
parts. Fourth, the approach raises few objections from any of the parties because
the value reflects the latest trend in the market. Fifth, the value automatically
accounts for all the factors, such as economic conditions, interest rates and so on.
The approach suffers from a few drawbacks, however. First, it may be diffi-
cult in practice to find a property that exactly resembles the property in ques-
tion. Second, the condition of the house has a bearing on the value of the
property. Third, the foundation of one property may be radically different from
that of a nearby property because one does not really know what lies below the
earth; even with short distances, the underlying structure could change. Fourth,
the value of comparable property indicates past trends and takes no account of
the future. Fifth, buyers may be willing to pay a higher price for a property due
to sentimental value; if your grandmother'S home is being auctioned, for
example, you may be prepared to pay a much higher price, given the senti-
mental value attached to the house. Similarly, a sacred site may command a
much higher value than it ordinarily would. The market value approach fails to
take some of these aspects into account.
Despite the drawbacks of this approach, the market value approach remains
quite popular with bankers for the valuation of property. It is important, how-
ever, to ensure the comparable properties are chosen with care. It should not
include a property that has been sold under duress or where the sale transaction
was not at 'arms length'. The property valuer also has to account for factors
such as location, view, design appeal, the time elapsed between the sale of com-
parable property and the valuation of the property in question, the quality of
construction, the age of the property, condition, the size of rooms, the quality of
interior finish and so on. Based on experience, the valuer places a value on each
of the adjustments that need to be made, and accordingly scales up or down the
property value. The following example of land lot prices in table 6.1 illustrates
the procedure.

TABLE 6.1 Comparable sales data
Size Price
Date Zoning (squaremetres) Price($) ($/squaremetre)
September 2001 B1 100 45000 450
January 2002 B1 150 72300 482
May 2002 Bl 180 78480 436
August 2002 Bl 120 60360 503
November 2002 Bl 140 69160 494
Averaging these prices produces an estimate of $473 per square metre. If the
property in question has an area of, say, 160 square metres, then it will be
valued at 160 multiplied by 473, which equals $75680. The highest and lowest
prices in the comparative table are sometimes excluded and the middle range of
prices is averaged. The raw sales data are just one component of the appraisal
process. The actual valuation depends on other factors such as environment,
shape and topography.
Thecostapproach
This approach, also known as the summation approach, involves calculating the
cost of each of the improvements made to the property and adding all of these
to arrive at the value of the property. First, the valuer determines the value of
the site (land) on which the property is located, and adds up all improvements
made there. The valuer deducts any depreciation to the property. The valuer
selects comparable sites that have recently been sold and, after making adjust-
ments for locations, shape, size and so on, calculates the value of the land. The
value of any structure built on the land is based on its construction cost. The
cost of construction includes the cost of materials, labour and overheads, and
the profit margin. Cost manuals (usually available from the local council) can
be used. As a further check, the valuer may consult local construction firms.
After calculating the total cost, the valuer needs to scale it down for depreci-
ation due to normal wear and tear of the property, a change in the style of con-
struction, or economic conditions. Changed neighbourhood conditions such as
the establishment of a new airport nearby may raise the noise levels and bring
down the demand for properties in the area.
The cost approach provides a near accurate estimate of the property value if
the property is new and few adjustments are required to arrive at a valuation. It
has certain advantages. First, it gives a more accurate value of the property
because it accounts for all the expenditure made on the property. Second, there
is no need to find a comparable construction (which is often very difficult) for
valuation purposes. This approach suffers from some drawbacks, however, such
as the difficulty of obtaining accurate cost estimates, and disagreement over the
costs to be included or excluded.
-
Suppose the house property has been sold for $1 89000 and the land is worth
$40000, then the components of value could be apportioned as follows:
• sale price of the property with house $1 89000
• value of land $40000
• value of improvements $1 49000
-detached garage (replacement cost net of depreciation) $1 5000
-fencing $8000
-house (brick, tiled roof, four bedrooms etc. of 200 square metres) $1 26000.
The value of the house alone, as arrived at above, can be used to value a
house under consideration, provided it is of comparable age, condition and type
and in the same location.
Thecapitalisation
approach
This approach uses the ratio of rental income from comparable properties and
their sale prices as the basis of valuation of the property in question. If the
annual rental-sale price ratio for a comparable property is found to be 20 and
the property to be valued would be expected to earn a rental income of $1 0000
per year, then the value of the property will be $200000 ($1 0000 multiplied by
20). This approach has some advantages. It is easy to ascertain the annual rental
value of a unit, so calculations are not too hard. The approach may be suitable
where a property consists of many units in the same building, which makes it
easier to value the property. The method is often used for the valuation of com-
mercial property.
The capitalisation method is sometimes called the years purchase method or
the net income multiplier method, because the valuation of real estate under
this method entails multiplying the net income from the property by an appro-
priate factor. This factor is the years purchase or the net income multiplier. Sup-
pose the purchase price of a property is $450000 and the annual net income
from the property (gross income minus expenses) is $50000. This represents
nine years purchase (450000 divided by 50000), which gives a capitalisation
rate of approximately 11 per cent (100 divided by 9). Similarly, if the capital-
isation rate is available, one can easily calculate the value of the property
(50000 divided by 0.11). The capitalisation rate is derived from market trans-
actions wherever possible. The prices that are paid for investment properties
and their ratio to net income from the property show the nature and physical
conditions of the property, the contribution of improvements to the value of the
property, and the market's assessment of risk in relation to those properties.
Of the above three approaches to property valuation, lenders do not rely on any
single approach. In practice, property valuation is done using all three methods.
A banker may weigh each of the valuation approaches depending on the reli-
ability of the information used and accordingly decide the final value of the
property. Another consideration for the lender is to ensure the outstanding bal-
ance of the mortgage loan account is always less than the market value of the
property; that is, the value of the property should always cover dues under the
I 182 Part 3 Consumerlending I

mortgage. This aspect becomes particularly important in the initial years of a
loan when the application of interest may mean that the outstanding balance is
more than the value of the property.
Step-by-step
evaluationofhomeloans
Having explained all the major aspects involved in granting home loans, we will
now turn to the sequence of steps that lenders follow in assessing home loans.
These are not very different from the steps followed in assessing personal loans,
which we studied earlier.
Step 1: obtain the prescribed application form from the prospective borrower.
Ensure the applicant has provided full details in all the sections of the home finance
application. It is important to ensure the applicant has signed the application and
accepted various disclaimers, such as authority to give information to Credit
Advantage, authority to obtain certain information and verify personal details, and
authority to exchange information with other credit providers as required under
the Privacy Act 1988. It is also important to ensure, where a guarantee is involved,
that the guarantor signs the required sections of the application.
Step 2: once all the information has been submitted, the required docu-
mentation has been given and the application is in order, determine the appli-
cant's eligibility for the loan. At this stage, organise a valuation of the property,
perform checks (such as a character check) and determine the amount of loan
that the applicant can reasonably service from his/her income; that is, appraise
the loan as explained in more detail in subsequent discussion. Decide on the
repayment period, interest rate options, fees and charges to be levied, and so
on. If satisfied about the application, approve the loan and move to the next
step. Steps 1 and 2 normally take about one week. If the loan is to be rejected,
record suitable reasons for rejection in the loan application control register
(the loan log) and advise the applicant. Many banks have devised standard
formats for rejection letters. It is important to use those formats because a
loan rejection could have legal implications. Legislation requiring equal credit
opportunity, for example, prevents discrimination on racial, ethnic or sexual
grounds.
Step 3: if everything is in order and the loan is approved, then prepare the
loan offer documents. These comprise of a loan schedule (which contains the
financial particulars of the loan offered) and the usual terms and conditions of
lending. Also prepare the loan contract and send it to the applicant. The appli-
cant is usually given twenty-one days to sign and return the loan schedule.
Step 4: proceed if the applicant decides to accept the loan offer by signing it.
Call for information from the applicant's solicitor about the title of the property
al)d such other legal details. Also collect information from other financial insti-
tutions if re-finance is involved. If no adverse information comes to light, then
prepare the mortgage documents and request that the applicant signs these
documents. It is important to ensure the applicant and guarantor sign the
documents in the presence of an authorised bank officer. It is important to
explain clearly the financial implications of signing the loan contract and
mortgage documents to the borrower and guarantor. Obtain a signed declar-
ation to this effect from the borrower and guarantor. The declaration states that
the borrower/guarantor has consulted a financial adviser and understands all
the legal and financial implications in full.
Step 5: arrange for settlement of the loan transaction with the solicitor of the
applicant (or with the previous financial institution if re-finance is involved).
Debit the stamp duty and registration costs to the applicant's nominated
account and establish the loan. The borrower is now free to draw from the
account and make payments to a builder/contractor or the seller. This final
settlement is also called the loan closing. It is important to note that the
Uniform Consumer Credit Code requires banks to make full disclosure of the
closing costs to the applicant.
7.30 a.m.
It is Monday. I arrive at work, follow branch entry procedures, turn off the
alarms, enter my office and log on to the computer. Two important tasks for the
day are: to complete the spreadsheet detailing the previous week's results, to be
sent to the Area Manager; and to decide whether to approve the cheques of cus-
tomers who have overdrawn their accounts.
8.30 a.m.
There is a telephone call from a finance broker who runs a finance brokerage
company that assists clients with mortgage minimisation. He refers around $1.5
million per month in home loans to the bank. 1 advise that it sounds like a deal
and we can help.
9.30 a.m.
The home loan application of Mr and Mrs Smith is at hand. They want to
borrow $160000 against purchase security of $200000 (80 per cent loan-
security ratio). The property valuation showed a value around the purchase
price. No mortgage insurance is reqUired. I approve the faCility within my
authority because it meets the bank's capacity gUidelines and the clients' CRL is
clear. The clients also have stability in their residence and employment, as well
as a sound financial position. The file is placed in the internal bag to be docu-
mented by the bank's securities department.
10.30 a.m.
After a chat with the staff over coffee, I am back to my office and examine the
application of Mr and Mrs Collins, who were referred by another finance
broker. They have requested assistance with a house and landpackage. The
application looks fine but they can put in only 10 per cent deposit, which
mealY; the loan will need approval by a mortgage insurer. I complete the file and

forward the file to the mortgage insurer for underwriting. They will then
forward the file to securities for documenting once they have issued approval.
11.30 a.m.
Mr and Mrs Brown walk in to my office. Long-term cUstomers of the bank, they
require a loan of $150000 to invest in managed funds against their unencum-
bered property (valued by the bank at $300 000). There is no mortgage insur-
ance involved; the applicants' capacity, stability and previous credit are all
sound. I immediately approve the application.
12.30 p.m.
I receive a telephone call from Mr Armstrong, who wants to clarify his payout
figure on his home loan tomorrow because he has just been retrenched from his
employer. I provide the figures. After lunch, I attend to other routine correspon-
dence and duties.
3.30 p.m.
Mr Johnson telephones. We hold a current mortgage over his property and he
owes $50000. He wants to borrow a further $90000 to add a deck on the back
of the property, raise the property and build in under it, and also do some work
to the kitchen and bathroom. He has provided plans and specifications of the
work and believes that the property will be worth $290000 once the reno-
vations are complete. I advise that we will need to do a valuation of the pro-
posed work and also a valuation of the property after the work is completed. Mr
Johnson is happy with this. I give a conditional approval because his track
record is excellent and he holds a stable job.
4.30 p.m.
The branch closes for the day. The cashiers balance their cash and I sign their
end-of-day balance sheets, as well as the internal accounts passbooks. A brief
discussion of the day's events occurs before the safe is closed and the alarms are
re-initiated for the close.
5.00 p.m.
All staff exit the branch.
Source: Mr D. Pearse, former Manager, Sales and Service, Suncorp Metway Bank, Brisbane.
Financialappraisalofrealestateloans
The financial appraisal of residential mortgage loans is fairly straightforward. The
bank is interested in knowing whether the borrower can service the loan out of
his/her net income. The bank will calculate the loan instalment (monthly or fort-
nightly) based on three factors: the amount of the loan, the period and the rate
of interest. The lending officer will then check whether the borrower has sufficient
net surplus (income minus expenditure) out of which he/she can comfortably
repay the loan instalment together with interest. The websites of banks supply
loan instalment calculators, and by keying in the figures one can readily determine
the amount of the loan instalment. You can try this appraisal technique at the
website of Aussie Home Loans (www.aussiehomeloans.com.au). You may like to
find out how much you can borrow, as well as what your repayment schedule will
be, by keying in different loan, interest and amortisation (repayment) figures.
The financial appraisal of investment home loans could be more complicated
because property investment, like any other investment, is made with the aim
of obtaining a fair return. Investment appraisal methods that are used in any
commercial project are relevant in investment home loans as well. The banker
requests the borrower of an investment home loan to provide projections of
income and expenditure from the property, checks the validity of the projec-
tions made (that is, that the projections of income are reasonable and not too
optimistic), calculates the rate of return from the proposed investment, exam-
ines the cashflow from the investment and determines whether repayments can
be serviced out of the net returns from the property investment. This is akin to
a project investment appraisal but much less complicated.
Exampleofa realestateloanapplication
A Commonwealth Bank home loan application is downloadable from the bank's
website (www.commbank.com.au) or obtainable by visiting one of the bank
branches. In this section, we examine the home loan application to explain how
the information sought helps the lending banker to assess the quality of the
loan proposal. In so doing, we have tried to relate the questions in the appli-
cation form to the five Cs of lending (character, capacity, collateral, capital and
conditions) .
The details requested by the bank in a home loan application form are similar
to those required in personal or credit card loan applications. Given the type of
loan, however, additional information is sought. The following discussion refers
to the Commonwealth Bank home loan application:
• Page 1. This page contains questions about the purpose of loan and whether
it is a loan for an owner-occupied property or an investment property. The
bank will use these details for deciding the rate of interest to be charged on
the loan. (Banks may charge different rates of interest for owner-occupied
and investment property.) The information will also help the bank decide
whether the amount of loan required is appropriate or sufficient for the
purpose, along with the sources from which payment is to be expected. This
page also seeks details about the property to be purchased, such as the
address, the price, access for valuation, details of the contractorlbuilder and
so on. These details help the bank in visiting the property for valuation
purposes and verifying the cost/price of the property with the contractor/
builder. This information will be used for deciding the loan amount to be
approved. The availability of funds with the applicant and an estimate of the
total cost of purchase could help the bank determine the requirement of the
loan, whether the applicant has accounted for all the related costs and
whether these are reasonable estimates.

• Page 2. The three boxes for the applicant seek details such as the loan
required and repayment options. These are fairly easy to understand and
need no explanation. Please note the clause about lender's mortgage
insurance. Where the amount of loan exceeds 80 per cent of the value of the
property, the lender insists on mortgage insurance. This insurance protects
the lender in case of default but the applicant pays the premium. The fourth
box is asking information about insurance of buildings, content and life. The
bank is trying to sell insurance services to applicants - an example of
product cross-selling. The bank is also securing its position in case of an
unforeseen event such as an earthquake and may require the applicant to
assign the insurance policy in the name of the bank.
• Page 3. These two boxes seek information about the personal particulars of
the applicant and hislher financial position. The information in the first box
will help the bank to judge the character of the applicant. The details have
already been discussed in the context of a personal loan application in
chapter 5. The financial position box will help the bank judge the repaying
capacity and financial soundness of the applicant.
• Page 4. The second box is about the details of the solicitor whom the bank
may contact about the legal aspects of the sale-of-property contract and also
about the validity of title to the property. The bank will obtain all the
documents and keep them on record. The box containing the declaration of
the applicant cautions that there is no legally binding contract on the part of
the bank to lend. This means that the applicant would be wrong to presume
that by virtue of signing the form the loan stands granted. There have been
cases where applicants presumed the signing of the application form was
approval of the loan and took further actions, assuming that funds would be
available from the bank. The bank is taking extra precaution to ensure the
applicant does not carry such a wrong impression. Please study the last box
on this page of the form. It contains the most essential details that the bank
considers in making a decision on the application: the income that could be
used for repayment (total gross monthly income), and loan-value ratio
(LVR) or loan-security margin percentage, and lender's mortgage insurance.
It also seeks information such as the security arrangement and property
identification. In the end, the authorised officer will record and sign the
comments, recommendations and decision about the application.
The bank also obtains information such as the nomination to receive notices,
proof of identity, authority to obtain credit information about the applicant and
guarantor, and so on. All the forms cannot be reproduced here, for want of
space, but reading these forms and the clauses they contain would greatly facili-
tate understanding. The forms are available at the Commonwealth Bank of Aus-
tralia website (www.commbank.com.au/default.asp).Atthiswebsite.click on
'Products and services', then 'Personal centre' and then 'Home loans' to access
the forms and undertakings required by the bank. Please note that the forms
and requirements of all banks and nonbanks are similar.
/ -
Precautions
in grantingrealestateloans
A banker may face some of the following challenges while granting real estate
loans:
• Accurate factual information about the property is a prime requirement. The
valuation of property will be as good or bad as the information on which it is
based. Factual information on matters such as the area and dimensions of
land, title to the land, easements rights on the land, location, rentals and
tenancies needs to be available.
• Information about all relevant sales in the area should be available before
valuation can be done. Banks usually employ the services of approved valuers
or ask the borrower to submit a report from approved valuers.
• It is important to ensure the vendor has clear title to the property. The
applicant's solicitor usually takes care of this matter, but it is also important
for the lending officer to take adequate care.
• When finance is being given to build a new house on a piece of land,
permissions from local authorities must be obtained. These may include
permissions for items such as the water connection, electricity and telephone,
and approval of the SUitability of the site (foundation) to build a house. There
have been cases where a council declared land suitable for house
construction and houses were subsequently built with bank loans. The soil
later gave way and created huge cracks in the houses, making them
unsuitable for habitation. A bank can do little in such cases and has to rely
on the expertise of the local council.
• Individuals may withhold information that is crucial to the bank's
deCision-making. This may relate to health or employment issues. There
may also be inconsistencies in information provided by the applicant,
which may be intentional or due to lack of knowledge of bank
procedures.
• As stated in chapter 5, it may be difficult to verify some of the
information provided by the applicant. Employers may not be willing to
disclose details about their employees to the bank. The bank should be
very cautious in disclosing information about a prospective or existing
borrower.
• Individuals can be susceptible to sickness, injury, loss of employment and
other causes that may affect their ability to repay. Even family disputes can
affect the repayment performance of a borrower.
• The lending officer should carefully read the bank's loan policy manual and
observe the documentation reqUired and such other procedures.
• Head office advise the branches and offices of changes to the loan policy from
time to time. It is necessary to ensure loan officers are up to date with all the
changes.

Melbourne mother more
. ifiutdforged a mortgage document and then
"",nrT'P'" :the Jlome:;,'
CoullW)::'oU:1't ..... said Elizabeth Maher was entitled to
ttr anNAB branch manager added properties to the
mortgage· on .. Clayton home without their knowledge.
In an. delivered last week, Judge Murdoch slammed
the bank 'its very substantial financial strength' to 'recklessly
disregard' rights. Mrs Maher last night described the court's
decision as 'a greatvelief',
'When I heard.,!.· ....... d', Mrs Maher said.
Handing down· Judge Murdoch said the case raised 'matters
of a grave nattlrerr{)f.:the bank and directly affects its reputation in the
pay $450000 in aggravated and exemplary damages.

Moorehouse-Perks, said the judge's order 'repre-
of the conduct of the bank in never apologising to
in trying to evict her again'.
NAB, Haydn Park, said last night the bank was still
JO.",·j,... <.ut and would consider an appeal.
that in 1986 Mrs Maher's husband, Dennis Maher, had used

... .... home as security on a mortgage over two blocks of land in
Buchan, eastern Victoria.
Alexander McDonald, manager of the bank's Victoria Square branch in cen-
tral Melbourne, realised he had failed to acquire sufficient security on the loan,
the court heard.
He then fraudulently altered Mr Maher's mortgage, adding
properties.
Mr Park said Mr McDonald was still employed by the NAB. :...:...
The court heard that in October 1991 the NAB foreclosed on the loan and
evicted the Mahers and their six children by sending in a sheriff to dump them
on their nature strip.
The family had returned to the home on legal advice five months later.
Mrs Maher, who was not listed on the mortgage documents, then successfully
applied to the County Court for a claim of equitable interest in the three
properties.
It was during that application that the forgery came to light and Judge
Murdoch declared the mortgage void, allOWing the Mahers to remain in the
home.
Source: B. Haslem 1997, 'Evicted mum beats bank', The Australian, 17 February, pp. 1-2.
Trendsin realestatecredit
Here, we will review some of the recent trends in real estate credit in Australia.
The 1990s were a decade of quick growth in household borrowing. This can be
seen from figure 6.1.
25
20
15
e....10
C1I
01
s::::
as
c3 5
-5
1991 1993 1995 1997 1999

FIGURE 6.1 Household credit - twelve-month-ended percentage change
Source: Reserve Bank of Australia 1999, 'Consumer credit and household finances', Reserve Bank of
Australia Bulletin, June, p. 11.
The Reserve Bank of Australia noted that the home loans market in
Australia has shown growth due to innovation in bank products and low
home lending rates. It stated that 'intermediaries' lending rates have fallen
from a cyclical peak in 1996, to levels that are as low as they have been
since the early 1970s' (Reserve Bank of Australia 1999, p. 2). The changes
that have taken place in home lending interest rates during 1996-99 are
presented opposite in table 6.2.
The reduction in the pricing of loans has been witnessed mainly in the
home loan market, because the mortgage managers gained considerable
market share in the two years to June 1996. In recent years, banks have
reacted to the threat by aggressive home loan marketing and the share of
mortgage managers has declined (as seen in table 6.3).
I
190 Pari 3: Consumerlending
TABLE 6.2 Housing interest rates
Change from
Junequarter1996 to March1999 1999level
(percentage points) (%)
Banks
Standard variable -4.00 6.50
Basic -3.05 5.90
Mortgage managers
Standard variable -2.80 6.10
Basic 5.75
Cash rate -2.75 4.75
Source: Reserve Bank of Australia 1999, 'Recent developments in interest rates on bank lending',
Reserve Bank of Australia Bulletin, April, table 1, p. 2.
Trendsin homelending
Table 6.3 shows the trends in housing finance in Australia in the last half of the
past decade.
TABLE 6.3 Housing finance commitments, by type of original lender
Permanent
building Mortgage Other Mortgage
Year Allbanks societies managers lenders Total Banks' managers'
(Juneend) ($ million) ($ million) ($ million) ($ million) ($ million) share(%) share(%)
3461 161 487 254 4362 79 11
1i;:)998 4244 206 471 238 5159 82 9

0:: "c
11;>.1999 5292 215 506 270 6282 84 8
4629 162 551 258 5600 83 10
It2001 6074 328 1008* 290 7700 79 13
i 2002 6127 293 1258* 430 8108 76 16
* The Australian Bureau of Statistics used the term 'wholesale lenders' in this year.
Source: Australian Bureau of Statistics 1998-2002, Lending Finance, cat. no. 5671.0, Canberra, table 2.
Percentages are calculated from data.
Banks and mortgage managers are the two major players in the home lending
mortgage market. A look at the percentage market shares of mortgage managers
and banks shows a competition between the two. Despite the aggressive chal-
lenge, banks continue to dominate the home loan market, with a share of more
than 70 per cent.
Pricingandstructuring
ofrealestateloans
An important part of a lending banker's job is to price and structure the loan. In
the discussion that follows, we will explain some of these aspects.
Loanpricing
The pricing of a loan refers to the interest rate, fees and other terms on which a
bank gives a loan. Several factors influence the pricing of loans. These include
(but are not restricted to) sources of funds used for lending and the cost of
financing the sources, risk considerations, the national economic growth rate,
the rate of inflation and rates that competitors are charging.
Most lenders are financial intermediaries that procure funds from savers (depos-
itors) and lend to deficit units. When funds are borrowed by the intermediary from
the savers, they have to be repaid with interest. This is a financial cost of procuring
of funds and is always factored into the pricing of all loans, including home loans.
The following illustration in figure 6.2 explains how loan pricing takes place.
This pricing strategy is called the cost-pIus-profit pricing strategy. It is
explained in tables 6.4,6.5 and 6.6.
Borrower rating Facility rating

Borrower Facility Final price
Analyse borrower Price base

Characteristics Prime/London Inter Bank
Industry Offer Rate (LiBOR)
Financial statements Credit spread
Management Borrower rating
Business plans Tenor
Collateral
Guarantees
Covenants
Matching funding cost
Capital charge
Overhead
Other fees
Competition
FIGURE 6.2 Traditional loan pricing method

Source: J. B. Caouette, E. I. Altman & P. Narayanan 1998, Managing Credit Risk: The Next Great
Financial Challenge, John Wiley & Sons, New York, figure 18.1, p. 253.
TABLE 6.4 Historic loss rate, by internal risk rating
Historicfive-yearloss
Rating rate(%j
AAA=1 0.01
AA=2 0.19
A=3 0.18
BBB=4 0.85
BB=5 6.15
B=6 18.38
Financial Challenge, John Wiley & Sons, New York, table 18.1, p. 253.

TABLE 6.5 Term structure of rates
Maturity(years) Costof funds(%)
1 5
2 5.5
3 6
4 8
5 10
10 12
Financial Challenge, John Wiley & Sons, New York, table 18.2, p. 254.
TABLE 6.6 Price build-up based on cost plus profit
Item Calculation Amount
i;i 1. Borrower's risk rating 5

" 2. Loan maturity 5 years
'"" 3. Five-year loss rate (mortality) 6.15%
4. Capital ratio 8.00
: 5. Hurdle rate 16.00
" 6. Loan amount 1000000
7. Capital required (8 per cent of loan amount) (0.08) (l 000 000) 80000
Pricebuild-up
8. Annual capital charge @ 16 per cent (0.16) (80 000) 12800
9. Annual funds cost@ 10 per cent fixed (0.10) (920000) 92000
:l0. Annual loan loss allowance (0.0l) (6.15) (l 000 000) + 5 12300
(,IL Break-even annual interest income (12800 + 92 000 + 12 300) 117100
;'12. Loan interest rate (with no funding risk) 117 100 + 1 000 000 11.71%
;,13.Minimum spread 11.71 - 10.00 171 bps
Source: J. B. Caouette, E. I. Altman & P. Narayanan 1998, Managing Credit Risk: The Next Great Financial Challenge,
John Wiley & Sons, New York, table 18.3, p. 254.
Note that the hurdle rate means the required rate of return on capital. Regu-
latory capital, or capital required at 8 per cent of the loan amount, refers to the
capital that is required to be held as per capital adequacy norms. These norms
require that lending institutions hold at least 8 per cent of risk-weighted assets
as capital. For details of the capital adequacy norms, visit the website of the
Australian Prudential Regulation Authority.
Calculation
ofinterestonloans
In Australia, interest rates on loans generally take two forms. Fixed interest rates
do not change over a set period. You will have seen bank advertisements about
fixed rate home loans where the interest rate remains fixed for one year, three
years or five years. Generally, fixed interest rates are higher than variable interest
rates, because the lender is bearing the interest rate risk. If the interest rates go
up, then the lending institution loses because it receives only the contracted rate
of interest on the loan. If, however, the market interest rate declines, then the
borrower loses because he/she could obtain the loan at a cheaper interest rate
than that he/she contracted to pay under the fixed interest rate arrangement.
Where fixed interest rates are charged, repayments are set for the duration of
the loan period, regardless of any movement in market interest rates. Some bor-
rowers find fixed interest rates easier for budgeting because the loan repay-
ments do not change for an agreed period. A fixed rate loan gives rise to interest
rate risk for the lender, so it may charge a little higher interest rate to the bor-
rower to cover this risk.
Banks issue variable rate consumer loans, for which the interest rate varies
as conditions change in the market. This means the borrower's repayments
may vary during the term of the loan. In a variable interest rate loan, known
as an adjustable rate loan in the United States, the borrower shares the risks
of a fluctuating interest rate in the economy alongside the lender. Variable
interest rate loans generally have no pre-payment penalties. The interest rate
is fixed by adding a mark-up (risk premium) to the prime lending rate
decided by the bank. If the prime lending rate is 10 per cent and the mark-up
is 3 per cent, then the variable interest rate will be 13 per cent. If the prime
lending rate moves up to 12 per cent, then the interest rate will automatically
move to 15 per cent. Leading newspapers routinely publish the interest rates
charged by banks on various types of loan.
Determinants
of interestratesonhomemortgageloans
The demand for home loans is a derived demand because it depends on the
overall demand for housing. The demand for housing is influenced by
factors such as the number of households requiring housing (for example,
higher immigration creates a higher demand for housing), the income of
households, the size of households, taste and preferences, and the rate of
interest on mortgages. The supply of mortgage credit depends on, among
other factors, the financial cost of raising funds for the lenders, the cost of
originating and monitoring loan, the risk of loss from loan defaults and, in
the case of fixed interest loans, the potential loss due to changes in market
interest rates (the cost of re-financing). While deciding on the funds to be
committed for mortgage loans, lenders also consider the returns from other
competing loan forms, such as business loans and farms loans. When the
lender feels that greater returns can be obtained by committing funds for
home loans rather than for other types of loan, it will commit more for
mortgage loans. As the supply of funds increases, the mortgage loan interest
rates will fall.
Whether the customer takes out a fixed rate loan or a variable rate loan, both
the banker and customer want to know the initial rate and the monthly repay-
ments. Each monthly repayment on a mortgage loan reduces a portion of the
principal and a portion of interest. In the initial period of the loan, the repay-
ment goes mainly towards payment of interest; in the later years, it goes mainly
towards repayment of the principal. As the loan approaches maturity, a large
part of the monthly instalment goes towards repayment of the principal. Rose
(1999) presented a useful formula (top of page 195) to help both loan officers
and customers determine whether the mortgage loan will be affordable.

MRP = (P x R x Y) + Z
where
MRP = the customer's monthly loan mortgage payment
P = the amount of the loan principal
R = the annual loan rate divided by twelve
Y = (l + R)t x 12
Z=Y-1
t = the number of years of the loan.
The factor 12 is included to restate the loan's term and annual rate of interest
in months.
Example
Using the above formula, for a loan of $50 000 with a twenty-five-year mortgage
and II per cent interest, the monthly loan repayment (MRP) will be $526.61,
where P equals 50000, R equals (O.ll + ll), Y equals (l + O.ll + ll)25 x 12 and
Z equals (Y - l).
Bankfees
Next to interest, loan pricing involves levying various fees. The average bor-
rower may have little knowledge about the fees being levied by banks. Each
bank decides its own fees depending on considerations such as overheads and
fees charged by competitors. In recent years, banks have been criticised for
charging exorbitant fees. One of the major banks in Australia charges the
following types of fee on mortgage loans:
• establishment fee (a fee for setting up the loan)
• security substitution fee
• fee for switching to another loan
• loan service fee
• progressive drawing fee
• lodgement fee consent
• settlement fee discharge
• statement fee
• administrative fee for early repayments.
loan structuring
Structuring of a loan refers to the repayment patterns and other terms agreed
between the bank and the borrower. A bank loan officer usually works with the
customer in proposing different pricing and loan structuring plans. The banker
and the customer agree on the pricing and structuring of the loan before the
bank makes a formal offer of loan. While proposing the various options, the
bank accounts for the customer's other debt obligations and the amount of loan
that a customer can reasonably service.
Two important elements of debt structuring are taking security for the loan
and deciding the loan covenants. Taking security over a borrower's assets (or a
third party's assets) is like insurance. It safeguards the lender in the case of an
unforeseen event happening. The term 'security' refers to both the asset against
which a loan is given and the documents (such as bonds, bills of exchanges,
promissory notes and share certificates) that establish ownership and payment
rights between parties. There are a number of different types of security, each
having their own specialised documentation. It is important that an authorised
bank officer signs, stamps and authenticates these documents. Documentation
should be completed at the branch, and loans should not be disbursed until all
documents are properly signed. The following documents are generally used in
real estate loans:
• a promissory note
• a mortgage deed - a contract, backed by a promissory note, that creates a
mortgage in favour of the lender during the currency of loan
• a letter of guarantee, which could be a personal guarantee
• a sale deed of the property being purchased or sold
• an assignment of shares or life policies, where the borrower gives an
irrevocable order that proceeds from life policies may be paid directly to the
lender
• a loan agreement form setting out the terms and conditions of the loan.
Another important aspect of loan structuring is finalising the terms and con-
ditions of the loan. The loan covenants (terms and conditions) are decided in
consultation with the borrower. A loan agreement form usually includes the
following covenants:
• repayments - the amount to be repaid each fortnight/month/quarter
• interest rates - variable, fixed or a variant
• securitylinsurance - details of the assets to be mortgaged or insurance
policy to be assigned
• a default clause - actions to be taken in the case of default
• a pre-payment clause - facilities for pre-payment; penalties for pre-payment
• fees - a schedule of fees and when these are payable
• stamp duty/government charges.
Whatislenders'
mortgage am!howdoesit work?
ins!!nmce
Lenders" mortgage insurance (LMl) is a facility that provides cowr to a lender if
thc balance of a loan is not fully repaid from the proceeds of the sale of a mort-
gaged property. H iSlorically. LMI enables lenders to meet the del1l level needs of
a customer \vhcre the loan equity may he insufficient, usually where a borrower
has less than 20 per cent of the required purchase price.
I 196 lendingI
Part3: Consumer
equity were forced to
i;)v the'c loan above the 80 per cent of
n:ll17 thatlllortgage over five years, at a
,"".,;('IM< .... , loan: Needless to say, this involved extra
the f()r both lender and borrower. The LMI

the lender that the borrower will repay. The
twenty-five to thirty years at the same interest rate
documentary costs. The LMI company receives
J<;-clQc>;1i_L>; $800, and no fees for providing the cover. For
receive an additional 20 per cent commission from
,note is that LMI insures the lender, even if the bor-

The borrower gets access as a result to a better loan
the borrower would owe the insurer the payment
LMI providers operating in Australasia: Housing Loan

Insurance Co., Mortgage Guaranty Insurance Co.
Sun Alliance, and Commercial Union.
are owned by major Australian and global companies
ratings ranging from AAA to AA-. Because of this sound
support, the Australian Prudential Regulation Authority has
allocating capital at a 50 per cent level for LMI covered loans.
The strength of the LMI industry is reflected not only in the lenders' prime
ratings but by the loan levels they insure at anyone time. Commercial Union,
for example, has over 140000 risks at any time valued at over $14 billion. The
industry has a low default rate, so low premiums are possible. This is mostly
because lenders spread their risk and have excellent approvals c
cesses.
Securitisation, the process of parcelling portfolios of loans and a
secondary investors to those parcels, would not exist competitively without the
LMI industry because the LMI companies' high credit ratings enable funds to be
raised cheaply. This has forced down rates across the whole housing industry.
Previously banks used to thrive on 4 per cent-plus rate margins. Now the mar-
gins have fallen to as low as 1-2 per cent.
As well, lenders are now able to restructure their own balance sheets by
translating loan assets into cash by putting them into a securitised parcel and
selling them to institutional investors. It has also resulted in dramatic compe-
tition from nontraditional lenders and originators.
Borrowers have never had so many options.
Still, while LMI is now insuring over 25 per cent of all housing loans, it was
never intended to replace sound credit diSciplines or cover all types of extran-
eous exposure.
(continued)
In fact, the industry succeeds because it relies upon a borrower's strong
credit history, capacity to service the debt, and the lender's assessment
skills. Also, its coverage does not extend to damage to the property which
might be caused by fire or other depreciable causes, other than market
value cycles.
Again, it should be emphasised, an LMI does not cover the person taking out
the loan. They remain liable to the LMI provider for any claim paid out.
Over the past thirty years, defaults or claims averaged less than 2 per cent of
policies in force. LMI is a financial risk cover which further underpins the
hOUSingmarket.
Current challenges in the housing market
Housing loans have been the most successful lending product in Australasia,
mainly because of the high home-ownership ethos, inflation rises in property
values, economic prosperity, and a disciplined, risk-averse lending environment.
The market is still very stable. Few losses are incurred by lenders where
reasonable equity, low leverage and stable employment exist. The difficulties
arise when one tries to quantify these tests of reasonableness against volatile
property values, which tend to erode equity in economic and supply cycles.
One must also consider the adequacy of leverage, allowing for spikes in interest
rates, and decide what constitutes job certainty
On top of these risks, lenders are always trying to grow their business in an
industry where margins are declining and competition is fierce. This has always
been a financier's challenge: matching risk strategy and economic performance.
LMI does insure most of the higher risk loans and covers risks from a wide
range of lenders and originators. Its claims analysis constitutes a good litmus
test of risks and returns.
So what are the emerging risk issues? And what are the fundamentalprpb-
lerns when borrowers are overcommitted, lose their jobs or endure
ship breakdown? The key issues appear to b e: , \· h , ; ' . : . ' · '
Volatility of the property value
Property prices are affected by supply/demand shifts which, in turn, are influ-
enced by interest rates, the underlying economic stability, choices about where
people want to live, and the availability of hOUSing stock. New housing is an
unseasoned market and invariably falls in value before it rises. The take-up rate
is affected by new projects under construction. In cities on the east coast, there
is an emerging oversupply of inner-city and suburban units, particularly bedsit
or lower quality products.
As well, the property market is infused with buyers who are buying out-
side their traditional markets - they may be residents of other States or
from overseas - and these buyers have been shown to pay substantially
more for a property than a local buyer would, often up to 26 per cent above
independent valuation.

Distressed loans with little equity tend to result in bigger claims. Most
claims to LMI providers occur two to four years after a loan was initiated. At
the moment, LMI claims are historically low, but they tend to be bigger in
value because the property market is highly volatile and property prices have
risen quite steeply. This suggests that those lenders that have traditionally
self- insured, even for loans of up to 80 per cent of the value, might not be
sufficiently insured [against] potential loss. Lenders should perhaps review
their traditional loan insurance guidelines. Why take a big risk for a small
cost when LMI cover is available?
Credit mitigation r- .. :.•
c
'
As lending marginSsIH:iuk, everyone has to look at their costs. This should be a

positive feature for all-jndustry that has bureaucratised the lending processes in
areas such as independent valuations, depth of legal validations and servicing
evid,ence duplication.
Much .of the processing can be done electronically. Efficiencies will continue,
but the merit of the simplified processes is yet to be tested in a market down-
turn. Lenders should also be aware of how robust or how vulnerable are their
credit validation processes. As lenders rely more and more on outside agents to
find potential borrowers, there is a potential for misrepresentation perhaps by
the borrower or the agent. Who will take responsibility for actually meeting the
borrower and verifying the data? Certainly not the lender in many cases.
As housing loans become simpler products, and more widely and easily avail-
able, the less lenders seem to be concerned about verification of credit quality.
They are very good at making sure all the necessary data [arel there, but not so
good at analysing and checking that data. These qualitative issues do not
usually get the attention they deserve.
Consumerism
Australia is increasingly becoming more litigious, particularly in areas
consumer law. Lenders are lOSingmore and more cases against consumers,
ticularly those cases that are seen to have an underdog borrowing partner. (See
the Supreme Court case of CBA v. Amadio (1983), the British case of Lloyd's
Bank v. Bundy (1975) and the appeal to Australia's High Court of Garcia v. NAB
(1988». A consequence of this is the limitations on guarantees, and moves by
lenders to structure loans with the guarantor taking on the role of borrower. An
example is where a young couple witli few assets.take out a loan with parents or
relatives, and later divorce or perhaps become bankrupt.
Invariably, the relatives race to their solicitors<to try to exit the liability. Even if
they lose the action, it can add considerable legal costs to the claim.
What lies ahead for lenders in this sort of environment, particularly as the
economic cycle declines or rates rise?
In Britain, legislation protects parties with eqUitable interests. For example, a
might be heldJn the husband's name, but it forms part of an asset base
(continued)
which would be shared by the wife in the event of a separation. If the husband
borrows and the lender later exercises its security rights, it may find itself
restrained by the courts because of estoppel by representation. That is, the
lender cannot deny the knowledge of a prior equitable interest, and it should
have sought that party's agreement as joint borrower or loan convenantor.
In the past in Norway and Italy, moratoria have been placed on lenders exer-
cising sales for up to three years to enable the wife to get out of the property
arrangement in an orderly manner. In some Australian cases (Australian Bank v.
Stokes (1985», the court allowed a life tenancy to the equity party despite a
legal mortgage being held. With a focus on the 'science of the deal', there is a
growing tendency to ignore qualitative factors. LMls usually only cover enforce-
able mortgages. Special agreements for extra cover can be arranged.
Similar examples of unenforceable loans are where family composite loans
are taken and parties later argue that they did not receive consideration or loan
value, did not understand the arrangement, or were relying upon a spouse or
perhaps influenced by a joint borrower. Lenders must revisit these issues.
Steering our way through the 'riskbergs'
The housing lending market is an exciting one where innovation is fanned by
competition. How do lenders 'steam on', yet retain their competitive pOSitions
by simplifying loans and offering price advantages, while averting the emerging
'riskbergs' that confound the performance line?
The answer is by forming a closer working alliance with all parties in the risk
equation, particularly portfolio owners, solicitors, valuers, marketers and LMI
providers.
LMI companies are the catalyst for the recent revolution in housing lending
distribution. Without mortgage insurance, the securitisers would not have been
able to raise funds at such competitive rates. The LMI has helped all lenders
expand their business more efficiently through agency-style structures.,:
Still, the lengthening chain between lender and borrower ;\hil\i'"lhii"a,ft\::'
the parties rarely get to meet personally. So greater reliance is placed ,
quality of intermediation, the veracity of data and the 'best practice' issues that:
emanate from legal environment that tends to support the consumer.
Lenders and assessors in our view have excellent data-gathering processes and
checklist systems which, in some cases, could be cut back further. The emerging
dangers are to do with the decline in the number of validation processes.
As well, too many lenders focus on the deal, to the detriment of the cus-
tomer's best interest. Just because a borrower has an asset elsewhere or there is
equity in the loan, doesn't mean the borrower is a good risk even if there is
mortgage insurance in place. Under a default, a lender must still bear all the
sale of security costs and arrears management costs. A closer working risk
relationship will enable both the lender and LMI provider, who are complemen-
tary risk parties, to prosper even if riskbergs loom.
Source: R. Not! 1998, 'What is lenders' mortgage insurance and how does it work?', The Australian
Banker, 112(5), pp. 186-7, 191. Reprinted by permission of the Australasian Institute of Banking and
Finance.
200 Pari3: Consumerlending I

It must be remembered that the loan documentation is obtained at different
stages of the loan. At approval stage, the lender normally obtains written con-
sent as required under the Privacy Act, documents that identify the borrower
(such as a passport and driver's licence), Credit Advantage reports and valu-
ation certificates. The bank will issue a letter of offer of loan and the borrower
will be asked to accept the terms and conditions mentioned therein. After the
loan offer is accepted, other documentation such as the deed of mortgage is
obtained. Where guarantors are involved, particular care needs to be taken.
Lenders may ask the guarantor to sign a letter to show he/she obtained the ser-
vices of an independent financial advisor/solicitor and fully understands the
extent of responsibility involved. The bank holds the signed security docu-
ments in safe custody.
Summary
l. What are real estate loans?
Loans given for the purchase of real estate are called real estate loans. Real
estate includes land, building and other improvements to the property. Real
estate loans can be for residential property or commercial property. Loans for
commercial property are generally classified as business loans. Loans for resi-
dential property (whether owner-occupied or investment property) are
generally classified as home loans.
2. How are real estate loan applications evaluated?
The financial analysis of owner-occupied home loans is straightforward. It
involves calculating the borrower's net income and his/her ability to service
the debt out of this net income. The financial analysis of investment home
loans follows the principles of business finance. It involves a calculation of
the internal rate of return of the investment and the borrower's ability to ser-
vice the debt from this return (as explained in chapter 2).
3. How are the principles of lending applied in practice?
The downloadable real estate loan application discussed on pages 186-7
shows that each of the questions in the application directly stems from the
five Cs of lending (character, capacity, collateral, capital and conditions).
4. What precautions are to be taken in assessing these types of loan
application?
Briefly, the precautions include ensuring the vendor has clear title to the
property, all the financial information has been obtained, relevant documents
are executed before disbursement of the loan, and proper monitoring and
follow-up are periodically conducted.
5. What are the recent trends in real estate credit?
As stated by the Reserve Bank of Australia, the home loan market has
shown growth due to innovation in bank products and low home lending
rates.
6. What are the various pricing aspects of real estate loans?
Pricing of home loans follows the general principles of loan pricing. Banks
have devised several solutions for home loans, given the competition in the
Australian home loan market. Attractive pricing strategies are used for dif-
ferent solutions. Fixed rate loans and variable rate loans are two principal
options available to borrowers of real estate loans.
encumbrance, p. 178 lessee, p. 177 mortgage insurance,

fee simple interest, p. 177 lessor, p. 177 p.176
freehold interest, p. 177 lien, p. 178 real estate, p. 177
hereditaments, p. 177 maturity, p. 176 risk capital, p. 176
jOint tenancy, p. 177 mortgage, p. 175 tenancy in common,
leasehold interest, p. 177 p.177
Discussion
questions
1. What are real estate loans and why are they important?
2. What factors have led to a rapid growth of home lending in Australia?
3. What is mortgage insurance? Why do banks insist on some borrowers
having mortgage insurance?
4. What is the LVR? What is the importance of the LVR in consumer
lending?
5. When interest rates on corporateibusiness loans are much higher com-
pared with home loans, why do you think banks still push home loans?
6. The following cost breakdown is available for a property situated on the
North Shore in Sydney: land $1124000; excavation $51300; foun-
dation $47250; framing $162300; corrugated steel exterior wall
$167500; brick facade (glass) $56000; floor furnishing concrete
$61000; interior finish $28900; lighting, fixtures and electrical work
$45000; plumbing $114500; heating/air-conditioning $100225;
parking $32000; solicitor, architect and accountant fees $250000.
Using the summation method, find the value of the property.
7. A house situated at 17 Dalzel Crescent, Toowoomba, is a five-year-old
brick house. It is in good condition with five bedrooms, three bathrooms
and an area of 210 square metres. It is located in a medium-quality
neighbourhood. Comparable houses B (four years old) and C (six years
old) are situated about 5 minutes walk away and have four bedrooms
each. They were sold for $140000 and $132000 respectively about two
weeks ago. House B has two bathrooms and house C has only one bath-
room. Using this information, work out the market value of the property
at Dalzel Crescent.
I
8. Using the market value approach, find the value of the following
property.
Property
tobevalued(A) Comparable
property
(B) Comparable
property
(C)
January 2001 April 2001

350000 415500
58000 69000
a (square metres) 134 145 154
90 94 92
e ($!square metre) 2413.79 2698.05
t ($/square metre) 400.00 448.05
2 minutes 3 minutes
20 28 27
2 2 2
New 2 years 4 years
tors 1 1 1
Brick Brick Brick
struction Average Average Average
Average Average Average
9. An apartment building is generating annual income of $250000. Oper-

ating expenses, including vacancies, total 55 per cent of this income.
The market supports a capitalisation rate of 12 per cent. Find how
much the property is worth using the capitalisation (income) approach.
10. A local banker has estimated the value of the property at 23 Sunnyholt
Road, Brisbane, to be $1 80000 using the market value approach,
$175 000 using the cost approach and $179 000 using the income
approach. If the banker puts weights of 30 per cent, 30 per cent and
40 per cent on the three values respectively, how much loan should
the manager advance if the LVR is 80 per cent?
References
andfurtherreading
Brueggeman, W. B. & Fisher, J. D. 1993, Real Estate Finance and Investments, Irwin,
Homewood, Illinois.
Reserve Bank of Australia 1999, 'Consumer credit and household finances', Reserve
Bank of Australia Bulletin, June.
Rost, R. O. & Collins, H. G. 1993, Land Valuation and Compensation in Australia,
Southwood Press, Sydney.
Sirota, D. 1994, Essentials of Real Estate Finance, Real Estate Education Company,
Chicago.
Wakefield, J. 2000, 'Lending with confidence: valuing property in the techno era',
Journal of Banking and Financial Services, February, pp. 10-13, 28-9.
Weerasooriyou, W. S. 1998, Bank Lending and Securities in Australia, Butterworths,
Sydney.

Introduction
Lenders, whether banks, credit unions, building socIetIes or others, make
lending decisions within the framework of law. A breach of this framework
could lead to legal disputes and unnecessary costs for the lender. It could also
lead to bad publicity in the media. Every lender must therefore be conversant
with the general legal framework that exists to support any loan or related
transaction. The legal framework affecting credit and lending decisions is very
wide. Other than the more general aspects, such as the banker-customer
relationship, it includes speCific aspects, such as mortgages, guarantees and
loan documentation. The subject is vast; it is hard to accommodate all the
aspects within the confines of a single chapter. In this chapter, we will focus on
the essential aspects, leaving aside the finer details (which legitimately belong
to a separate book). The legal aspects discussed here are more relevant in the
case of consumer and real estate loans. (Business or corporate lending involves
additional aspects, which are not covered in this chapter.)
Weerasooriya (I998) identifies twelve different pieces of legislation that
apply to bank lending. In addition, the law relating to bills of exchanges,
cheques and payment orders is also applicable. Of these twelve pieces of legis-
lation noted by Weerasooriya, we will not discuss: the law relating to agencies,
partnerships and companies; the sale of goods law; the law of carriage of
goods by sea and marine insurance; the law relating to documentary credits;
or private international law and conflict law principles. This legislation is
more relevant to business lending than to consumer and home lending. This
leaves seven different types of legislation of which a lending officer should be
aware:
• contract law • tort law
• property law • insurance law
• the law relating to guarantees • bankruptcy law.
• consumer protection law
Instead of explaining each of the above legislation under a separate heading,
we will discuss them as and when they are encountered in a typical lending
process.
Overviewofthelegalframework
forconsumer
andrealestateloans
The legal framework within which consumer and real estate lending decisions
are taken could be broadly classified into two phases. In the first phase, the
lender has to ensure some fundamental legal requirements are met before a loan
contract is signed. In the second phase - that is, after the loan is approved and
the loan contract is signed - a different set of legal requirements arise. We will
consider each of these phases in turn. The two phases of classification are
merely for understanding; in practice, the legal aspects overlap. The first phase
includes the following pre-loan approval legal aspects.
I 206 Part3 Consumerlending I

Contract
law:examining
thecapacitytocontract
A lender should first ensure whether the prospective borrower has the legal
capacity to enter into a loan contract. A prospective borrower who is not a
minor, not a person of unsound mind and not an adjudged insolvent can enter
into a loan contract. A minor is a person who has not attained 18 years of age.
A minor has no capacity to contract, so a lender has to ensure that the prospec-
tive borrower is not a minor. If a lender enters into a contract with a minor, the
minor can repudiate the contract. This is the reason that lenders often take
great precaution to ensure no overdraft arises in the accounts of minors. Simi-
larly, the lender has to ensure the prospective borrower is of sound mind. As per
law, persons of unsound mind can enter into contracts provided they are of
sound mind at the time of signing the contract and have the capacity to under-
stand the obligations arising out of signing the contract. The law also provides
that adjudged insolvents - that is, persons who have been declared bankrupt
by a court - have no capacity to contract.
How does a lender ensure prospective borrowers meet these legal require-
ments? Lenders require a prospective borrower to produce certain documents
and sign certain declarations. They require, for example, personal identification
in the form of a birth certificate, passport or driver's licence. From these docu-
ments, a lender can verify whether the person is at least 18 years of age. Similarly,
application for a driver's licence requires indicating whether the applicant suffers
from any mental or physical incapacity. A driver's licence therefore automatically
establishes the holder as a person of 'sound mind'; lenders need not probe this
issue further unless contrary evidence comes to notice. In addition, the loan appli-
cation form requires prospective borrowers to sign a declaration that they have
'read and understood' the particulars completed in the form. This further estab-
lishes that the borrower is of sound mind. To ensure the prospective borrower
has not been declared bankrupt, lenders again rely on the declaration to this effect
contained in the loan application. As shown in the consumer loan application
form of National Australia Bank (which can be found at the bank's website), the
bank requires a declaration from the prospective borrower that he/she has never
committed any act of bankruptcy. Lenders also require the prospective borrowers
to be residents, which is automatically established from a driver's licence, passport
or visa status. Before issuing a driver's licence, the authorities verify the applicant's
residency status. A driver's licence is thus a very useful document for the lender,
because it establishes age, mental status and residency. Lenders invariably keep
a copy of each borrower's driver's licence on record.
Consent
undertheprivacylaw
The Privacy Act 1988 (as amended in 1990) is one of the important Acts that
affects the lending banker. It imposes limits on the disclosure of personal infor-
mation by credit reporting agencies and specifies the circumstances in which the
information can be released. It also limits how banks or other credit providers
can use personal information contained in credit reports. The consumer loan
_ ... ""1 .a
application forms of banks invariably include a clause that authorises the bank
to obtain confidential credit information about the customer and also to
exchange that information.
The activities that are regulated by this Act include:
• applications for credit
• the use of, and access to, credit reports
• the security of credit reports
• reporting of defaults
• refusal of credit
• debt collection
• the access of individuals to credit reports and dispute resolution procedures.
All lenders need to be fully conversant with this Act and take necessary pre-
cautions to comply with its provisions. Section 18 of the Act is particularly impor-
tant. Section 18E(8)(C) allows the lender to give a credit reporting agency certain
personal information about the borrower, although lenders, as an abundant pre-
caution, normally obtain the consent of the applicant. By signing the consent,
the applicant acknowledges and authorises that the lender may give credit infor-
mation to a credit reporting agency. Section 1 8E(l) specifies the information that
can be given to a credit reporting agency, which includes:
• particulars establishing the identity of the applicant, such as full name, date
of birth and address
• the fact that the applicant has applied for credit and the amount of credit
requested
• the fact that the lender is a credit provider to the applicant
• payments that are more than sixty days overdue and where collection action
has commenced
• advice that payments are no longer overdue
• cheques drawn by the applicant for at least $100 which the bank has
dishonoured more than once
• serious credit infringement, if any, committed by the applicant
• whether the credit provided by the lender has been discharged.
To assess the application, lenders are able to obtain the following types of
information:
• the personal or commercial credit provided by the lender to the applicant
• the commercial activities or commercial creditworthiness of a person in
relation to personal credit provided by the lender
• the commercial credit activities of the applicant.
The applicant usually authorises the lender to obtain this personal credit
information from a credit reporting agency.
Section 18N(I)(b) authorises the lender to exchange information about the
applicant that could be used for assessing an application for credit, helping the
applicant to avoid defaulting on credit obligations, notifying other credit providers
of a default by the applicant, and assessing the applicant's creditworthiness.
Sections 1 8N(l)(bb) and 18N(I)(ga) authorise the lender to disclose infor-
mation to mortgage insurers and guarantors respectively.

As seen from the previous information, the Act does not preclude lenders
from giving a certain type of information about clients. Lenders invariably, how-
ever, take the additional precaution of obtaining clients' consent in writing.
TheUniformConsumer
CreditCode
The lender must also ensure compliance with the Uniform Consumer Credit
Code. The code commenced operation on 1 November 1996. Any business that
is engaged in the provision of consumer credit - as its main activity, as a part
of its activities or even as an incidental activity - is covered by the code. Sec-
tion 6 of the code states that the code applies to all credit provided to individual
debtors and strata corporations for wholly or predominantly personal, domestic
or household purposes whenever any type of charge is made for credit, regard-
less of the amount lent or interest rate charged. Importantly, it also applies to
related mortgages, guarantees and insurance contracts. Where credit is provided
wholly or predominantly for investment purposes, however, the code is not
applicable. The credit is presumed to be for private purposes unless the debtor
declares otherwise. The lender ensures this by asking the borrower to complete
a business purpose declaration form (see page 1 of the personal loan appli-
cation form of National Australia Bank, which can be found at the bank's web-
site). If the declaration is not completed, then the loan will be presumed to be
for private purposes and the provisions of the Uniform Consumer Credit Code
could apply. Section 7 of the code states that the following types of credit are
outside its purview:
• credit proVided for sixty-two or fewer days
• credit provided without prior arrangement (for example, where a cheque
account is overdrawn and there is no agreed overdraft)
• continuing credit contracts for which only an account charge is payable
• joint credit and debit facilities to the extent that the contract or any amount
or other matter arising out of it relates only to the debit facility
• bill facilities
• instalment insurance premiums
• most staff loans
• credit provided by pawnbrokers and trustees of estates
• classes of credit providers or contracts excluded by regulation (s. 7).
loan documents
underthecode
The code regulates the form and content of the credit contracts, guarantees
and mortgages to which the code is applicable. It requires that these docu-
ments must be legible and clearly expressed. Section 162 also specifies
requirements in relation to print and type size. Sections 14 and 15 set out
the requirements in relation to credit contracts. Credit providers are required
to give the debtor a pre-contractual statement that includes details such as
the credit provider's name, the amount of credit, credit fees and charges,
interest charges, the annual percentage rate and repayment terms. All credit
contracts have to be in writing. Section 55 states that the liability under a
guarantee may not exceed the amount of the debtors' liabilities under the
credit contract and the reasonable enforcement expenses of enforcing the
guarantees. Section 53 states that a guarantor may elect to withdraw from the
guarantee by notice in writing any time before the credit is first provided.
Section 44 does not allow third-party mortgages unless the mortgagor also
guarantees the debt. Section 41 requires the mortgage to identify or describe
the property being mortgaged. Section 43 requires, for a mortgage to be
enforceable, the credit provider to give a copy of the credit contract or
guarantee (which is secured by the mortgage) to the mortgagor and to obtain
the mortgagor's written acceptance that the mortgage is to extend to that
credit contract or guarantee.
Monetaryobligations
ofthedebtor
The code also regulates the calculation of interest. Sections 26 and 27 prohibit
interest from being charged or debited in advance. The code permits, however,
charging of default interest in respect of the amount in default and while the
default continues. It regulates when statements of account are to be sent and
what they should contain. The debtor can repay the whole amount of debt early
and a credit contract cannot forbid early repayment of the amount owing under
the contract.
Feesandcharges
Credit providers can charge any type of credit fees and charges, provided full
disclosure is made to the debtor. The court has a right to annul or reduce the
amount of fee or charges if, in its opinion, that amount is unconscionable.
Where the credit providers have to pay fees or commissions to third parties (for
example, a lender's mortgage insurance), the exact amount can be passed on to
the debtor. This means that any discounts received by the credit provider also
must be passed on to the debtor.
Otherimportantclauses
The following are further important clauses from the code:
• Where the contract is of $125 000 or less, the debtor may request a variation
of the contract if facing hardships such as illness or unemployment.
• Harassment and unsolicited visits by a credit provider to the home of the
prospective debtor are prohibited.
• Consumer leases - contracts for the hire of goods by a natural person or a
strata corporation where there is no option to purchase the goods - are
covered by the code.
• Section 119 states that a credit provider may be liable for defects in goods
and services supplied (or other breaches) under a sale contract if the credit
provider is 'linked' to the supplier of the goods or services.
Penaltiesfornoncompliance
The code contains more than forty speCific civil penalties for noncompliance and
creates almost sixty speCific criminal offences. The amount of the civil penalty
210 Pari 3: Consumerlending

depends on who makes an application to the court. If the credit provider or a
government consumer agency makes the application, then the civil penalty is
limited to $500 000 nationally per contravention. If the debtor or guarantor
makes the application, then the civil penalty can be the whole of the interest
charge under the contract. There could be an additional fine of $10000 for every
contract that does not comply with the disclosure requirements.
Section 182 states that any person who is in any way concerned with, or a
party to, the commission of an offence under the code is personally liable as if
that person committed the offence. If a corporation contravenes the provisions
of the code, then any officer of the corporation who knowingly authorised or
permitted the contravention is personally liable as if that person committed the
contravention.
Tradepractices
legislation
The Trade Practices Act 1974 regulates the conduct of the business community
so as to encourage fair dealing at all levels of business. Banks have to account
for the provisions of this Act as far as they relate to anti-competitive and decep-
tive trade practices. Weerasooriya (1998, p. 411) noted that:
... the [Act] is now used in litigation against banks as a substitute for, or in
addition lO, the common law. The ... provisions that are commonly resorted to are
s.52 relating to 'misleading and deceptive' conduct and s. SlAB relating to
'unconscionable' conduct. Banks loan transactions are challenged under these
provisions.
The· following are among the important provisions of the Act of which a
lender should be aware:
• The Act generally applies if the amount of the claim does not exceed
$40000. Weerasooriya (1998, p. 412) stated that 'if the cost or price of the
banking service complained of exceeded $40000 the TPA will not apply'.
• Most cases under the Act are filed under the section on 'misleading and
deceptive' conduct (s. 52).
• Section 52A deals with unconscionable conduct. Its provisions apply to the
borrowing of money to buy a private residence, which is treated as 'service to
a person'.
• Bank staff who are found to have aided, abetted or conspired to contravene
some of the Act's provisions could be held personally liable.
• A three-year limit applies to all claims under the Act. This means that action
under the Act must be commenced within three years of the occurrence of the
event.
• Some famous cases filed against banks under the Act include the Amadio case
and the Nolan case. In both cases, the bank managers' conduct was found to
be fraudulent, unconscionable, misleading and deceptive. As discussion of
details of these cases can be found in Weerasooriya (1998).
The Australian Competition and Consumer Commission (among other entities),
which is an independent statutory authority, administers the Act.
Legislation
dealingwith contractsandconsumers
The Contracts Review Act 1980, the Fair Trading Acts and the Consumer
Transactions Act 1972 are State-level statutes, which have the object of
protecting consumers and striking down unfair and unjust contracts. The
Contracts Review Act is New South Wales legislation, while the Consumer
Transactions Act is South Australian legislation. The Fair Trading Act of
each State is similar to the Commonwealth's Trade Practices Act. According
to Blay and Clark (1993, p. 599), 'The [fair trading] legislation was largely
designed to overcome the constitutional limitations of the Trade Practices
Act 1974 which applies largely to corporations'. Fair Trading Acts apply to
individuals.
The second phase of lending is concerned with the legal aspects of pre-loan
approval: loan documentation, the rights and obligations of bankers and cus-
tomers, actions in the case of default and other relevant issues. In the following
sections, we will discuss each of these aspects.
Loandocumentation
Lenders require borrowers to sign many documents before the disbursement of
a loan can take place. Lending officers are often warned not to disburse a loan
until the necessary legal documentation is completed. The loan documents are
elaborate and carefully drafted by the lender's legal advisors. It is often said that
the documents are designed to protect the lender in all situations and may not
be in the best interests of the borrower. Staff are often advised to adhere to the
standard documentation prepared by the head office and not to make any alter-
ations without express authority. This is necessary because the legal advisors of
the lender consider past cases and incorporate suitable clauses to protect the
lender from an eventuality. The complexity of documentation has resulted in
several court cases in Australia and overseas, prompting moves towards drafting
the documents in plain and commonly understandable English (see Weera-
sooriya 1998 for a detailed discussion of these issues). There is still a long way
to go, however, and the documentation remains quite complicated. As a result,
lenders often take an undertaking from the borrower that he/she has consulted
legal experts and understands hislher obligations by signing the documents.
Lending officers should be cautious about offering any interpretation of the
clauses in the documentation; a safer alternative is to advise the client to con-
sult a solicitor.
Having understood the common difficulties faced by borrowers and the pre-
cautions that lending officers should take, we will now turn to other details
about documentation. From the loan application form of the Commonwealth
Bank of Australia (see the bank's website, as instructed on page 186, chapter 6),
we know that lenders obtain the following types of document before advanCing
consumer/real estate loans.
I 212 Part3: Consumerlending

Promissory
note
A contract of loan arises when one person lends or agrees to lend money to
another person in consideration of a promise (express or implied) to repay the
loan with or without interest. Such a promise is made in the form of a
promissory note. It is a basic loan document and is invariably obtained by
banks in all types of loan, whether for personal or business purposes. It is a
simple promise to pay the interest and repay the loan amount borrowed.
Mortgage
deed
A mortgage is the transfer of an interest in a specific immovable property to
secure a loan. The party transfering such an interest is called a mortgagor, the
transferee is called a mortgagee, and the transfer instrument is called a mort-
gage deed. Various forms of mortgages are recognised by law. The forms com-
monly found in Australia are legal mortgages, statutory Torrens mortgages and
equitable mortgages. Weerasooriya (1998) lucidly explains the difference
between a legal mortgage and a statutory Torrens mortgage. A legal mortgage is
the conveyance or assignment of the legal estate of the mortgagor in property
(real or personal) to the mortgagee. Under the Torrens system, the mortgage
takes the form of a statutory instrument which, when registered, confers on the
mortgagee an interest in the land. In a legal mortgage, the legal interest in the
property is transferred to the mortgagee. In the Torrens system, the legal
interest remains with the mortgagor and only equitable interest is transferred to
the mortgagee. As opposed to legal mortgages, in an equitable mortgage, the
mortgagor does not make a legal transfer of a proprietary interest, but merely a
binding undertaking to confer such an interest. The mortgagor has a right to
payoff the debt and redeem property. Banks use standard forms to obtain a
mortgage. Specimens of a promissory note and a mortgage deed can be found in
Sirota (1994); specimens of lending documents can be found in Francis (1987).
Guarantees
A guarantee is one of the Simplest forms of security taken by lenders. A
contract of guarantee is a contract to perform the promise or discharge the
liability of a third person in the case of default. The principal debtor or the
borrower is a person for whom the guarantee is provided. The person who
provides the guarantee is called the guarantor and the person for whom the
guarantee is provided is called the creditor. A guarantee covering a Single
transaction is called a specific guarantee, while a guarantee covering a series
of transactions is called a continuing guarantee. The liability of the surety
(the guarantor) depends on the default of the third party (the principal
debtor). Given that all the parties to a guarantee - that is, the guarantor,
the principal debtor and the creditor - subscribe to the contract, any
changes to the terms of the original credit contract must be made with the
consent of the guarantor. The guarantor is discharged from liability if the
terms of the contract between the principal debtor and the creditor are
changed without hislher consent. In the case of a continuing guarantee, on
the death of the guarantor, his/her estate will not be liable for future trans-
actions. The guarantor can revoke a contract of continuing guarantee by
giving suitable notice. If the principal debtor is released, then the guarantor
is automatically released. Lenders usually obtain a continuing guarantee and
use standard forms to obtain guarantees.
Billofsale
Hire purchase companies use this type of security when lending for motor
vehicles. It is important to ensure the bill of sale is properly drawn. It
should be prepared on the usual stationery of the vendor (the vendor's
printed forms), bear a current date (not be a stale bill) and be signed with
the seal of the vendor. It should be ensured that the bill of sale indicates
the registration number of the vendor and is drawn in the name of the bor-
rower, indicating the borrower's full address. When such a bill of sale is fur-
nished by the borrower, the lender should confirm its veracity. Lenders
usually make payment directly to the vendor against delivery of the goods
specified under the bill of sale. The bill of sale is a primary document of
evidence of the sale contract.
Anassignment
ofsharesorlifepolicies
Assignment means a transfer of a right, property or debt by one person
(assignor) to another person (assignee). The borrower gives an irrevocable
order that the proceeds from life policies may be paid directly to the lender.
In the event of default, the creditor has a right to enforce the assignment and
use the proceeds towards the satisfaction of the debt. Lenders consider
assignment of life policies to be one of the most satisfactory forms of
security. This is because the value of the security (assignment) can be readily
ascertained, it is stable and it can be easily realised. Lenders often prefer
assignments to guarantees. According to Weerasooriya (1998), a life policy is
considered to be a much more tangible, reliable and acceptable banking
security than the average guarantee. Another security that lenders may
accept is the company shares that are listed on the stock exchange. Lenders
normally accept only those shares that are quoted and marketed in recog-
nised stock exchanges. They prefer shares of blue-chip companies such as
BHP Billiton, Lend Lease and Amcor. Although value of shares may fluctuate
(and even sharply at times), the prices can be readily ascertained and the
shares can be readily sold. Lenders normally insist on legal mortgage of
shares. This means the debtor assigns it in favour of the bank by filling in
the share transfer form, which can be obtained from the relevant company.
Such a transfer usually takes place subject to an agreement that the security
will be transferred back to the borrower when the loan is repaid. Transfer of
the shares in the name of the lender incurs a transfer fee. Once the fee is
paid, the share registry of the company issues a holding certificate (called a
share certificate overseas) in the name of the bank. To save the transfer fee,
I 214 Pari 3: Consumerlending I

lenders may sometimes accept an equitable mortgage of shares. In such an
arrangement, the share certificates are deposited with the lender with the
intention of creating a charge thereon. Lenders obtain a memorandum of
deposit signed by the shareholder (the borrower).
Loanagreement
formsettingoutthetermsandconditions
oftheloan
Probably the most important loan document is the contract of loan. Under a
contract of loan, two parties (the lender and the borrower) make promises to
each other. The lender promises to pay a sum of money to the borrower, who
promises to repay the advance on demand or after a fixed period together with
interest. The promise to lend generally takes the form of either a loan or an
overdraft. Under a loan agreement, the lender promises to pay money to the
borrower on the terms of a written agreement. Under an overdraft agreement,
the lender (if a bank) agrees to honour the cheques drawn by the customer,
usually up to a certain limit. Several legal aspects need to be considered in a
loan contract. These include general contractual considerations, repayment
terms, interest and other costs. We will consider each of these in the following
sections.
Generalcontractual
considerations
The loan contract obliges the lender to provide a loan to the customer if the
customer fulfils certain conditions as laid down under the contract (for
example, provision of security). If the lender fails to do so, then the customer
can sue the lender and claim damages. Lending officers must be careful not to
give any impression to the customer to the effect that the loan is approved
unless such a decision has been made. It is always advisable to send loan
approval (a loan offer) in writing and inform the customer that the contract
does not come in force until the offer is accepted and the terms and conditions
of the loan offer are satisfied.
Repayment
terms,interestandcosts
The repayment terms depend on the nature of the loan. Demand loans are loans
repayable on demand, while term loans are repayable at the end of the fixed
term. Where the loan is a demand loan, the lender has a right to recall the loan
at any time without assigning any reasons.
The right to receive interest is expressly stated in the loan contract. The interest
rate may be fixed or floating. Lenders normally publish their indicator lending
rates. In a floating rate arrangement, lenders charge a premium on the indicator
rate to cover risk and provide a return over the cost of the funds. A borrower
may seek to borrow at a fixed rate to lock-in financing costs. Lending at a fixed
rate, however, exposes the lender to the risk of loss if its own cost of funding
rises above the rate that it charges the customer on its loan. Under the Banking
Act 1959, the Reserve Bank of Australia has the powers to control the interest
rates being charged by banks. Since deregulation, however, the Reserve Bank has
permitted banks to fix their own interest rates, and has only an indirect control
over interest rates. The Reserve Bank's cash rate (which is an interest rate that it
charges banks) has a bearing on the interest rates being charged by banks to their
customers. Changes to the cash rate indirectly influence the interest rates charged
by banks. When the cash rate is lowered, banks can borrow at a cheaper rate of
interest from the Reserve Bank and may pass on the benefit to customers. Simi-
larly, when the cash rate is raised, it Signals to the banks that tighter monetary
conditions are to follow; in turn, banks restrict their lending activities by raising
their interest rates. Through the mechanism of the cash rate, therefore, the
Reserve Bank indirectly influences the lending rates in the market.
Other than the interest rates, lenders also charge fees. Two common fees are
the establishment fee and the commitment fee. The establishment fee is payable
on the signing of the loan agreement and usually deters the borrower from
pre-paying the loan. The commitment fee is charged by the lender for setting
aside funds out of which the loan is to be made. Loan agreements generally do
not attract a stamp duty, but any security provided for the advances under the
loan agreement attracts ad valorem duty.
Bank charges, fees and interest often attract public attention. There is a per-
ception that bank charges are excessively high. The Banking Ombudsman in
Australia receives many complaints related to bank charges, fees and interest,
which comprise the second major area of consumer complaints.
Execution
ofdocuments
It is important that lenders take adequate care to ensure the correct documents
are executed (see figure 7.1, pages 218-19, for real estate loans). Documents
should be correctly drafted, duly stamped and properly executed. Documenta-
tion forms a permanent record of the rights and responsibilities of the parties
involved (the lender, the borrower and the guarantor). In the event of death of
the borrower, the lender's claim over the property of the deceased can be easily
established with the help of documents. The following precautions need to be
taken while executing documents.
Partieswhoexecutethedocuments
Generally, the borrower executes the documents. In some cases, however, the
borrowers may give a power of attorney to another person, although such
instances are rare in consumer loans. The original power of attorney must be
examined to ensure it has been properly executed and confers the requisite
powers on the attorney to execute the documents and bind the principal. It is
important to ensure the executants (parties executing the document) are com-
petent to contract - that is, they are not minors, persons of unsound mind or
adjudged insolvents. The power of attorney may be for a particular contract or
it may be a general power of attorney. A photocopy of the power of attorney must
be held on record after being examined along with the original. The borrower
should be asked to sign the photocopy, with a declaration that it is a true copy
of the original. The copy should then be authenticated by the lending officer.

On the side of the lender, an authorised representative generally signs the
documents. In a bank, the branch manager usually signs all documents on
behalf of the bank. The authorised representative should sign the documents in
full and put the seal of the lender on the document.
Signingofdocuments
Loan documents must be executed in the presence of the authorised represen-
tative of the lender. All the parties must sign the documents in full (not initial)
according to their usual specimen signature. If a document has several pages,
then all the pages should be signed in full by all the parties to the loan contract.
No cutting, deletion or alteration should be made on the document. Any
change that is required should be duly authenticated by the executants.
Formsandcontents
ofa loandocument
All lenders have prescribed forms for different types of loan document.
Lenders' solicitors draft these forms to protect the lenders' legal interest.
Lending officers should not make any deviation from any of the prescribed
forms or clauses included therein without express authority from the head
office. Where a mortgage deed of the immovable property is to be executed, it
should be ensured that full details of the property (location, zone, boundaries,
house number and so on) are included. All the title deeds in respect of the
property should be handed over to the lender. In many cases, lenders insist
that the sketch (plan) of the property is attached to the mortgage deed. The
deeds often include a clause that authorises the lender to inspect the property
mortgaged. Lenders also require the borrower to take out insurance of the
property (for example, house insurance). The law requires that two witnesses
attest the mortgage deed; if not attested, then the deed may be considered to
be void.
Balanceconfirmation
letters
Lenders periodically obtain balance confirmation letters from the borrower,
confirming the loan outstanding. Such confirmation letters should be signed
by the borrower and held on record by the lender. Where there are joint
borrowers, balance confirmation letters should be obtained from each of the
parties.
A balance confirmation letter serves as an acknowledgement of debt and
can be provided in a court of law as evidence of the outstanding amount of
a loan.
Stampduty
Every State and Territory provides (for example, the NSW Stamp Duties Act
1920) that instruments that are subject to stamp duty are unenforceable unless
duly stamped. Ad valorem (according to value) duty is imposed on conveyances
such as loan securities and leases. Please note that stamp duty varies from State
to State, so the stamp duty requirements depend on the State within which the
documents are executed and registered.
Document Required: In file: Comments:
General information
Credit report/references
Partnership agreement
Verification of corp_ legal name
Resolution to borrow
Resolution to deposit
Commitment letter
Loan information
Copy of note
Loan agreement
Modification agreement
Guarantee
Assignment of life insurance
Annual finance statements
Reliance letter
Interim financial statements
Financial statement spreads
Required ratios
Personal financial statements
Business tax returns
Personal tax returns
Balance/deposit requirements
Real estate collateral

ABI in trust
Trust agreement
Mortgage
Assignment of R.E. contract
Lease/rent assignment
Title commitment
Title policy
Appraisal
Appraisal engagement letter
Appraisal review form
Survey
Insurance
Prior liens
Flood documentation
Rent roll
Lease
I 218 Pari3: Consumerlending I

Document Required: In file: Comments:
Environmentaldocumentation
Environmental indemnification
Environmental screening report
Phase I audit/site inspection
Phase II aUdit/site inspection
Other collateral/fixtures
Security agreement
Third-party pledge/hypothecation
[Council] financing statement
State financing statement
[Council] lien search
State lien search
Insurance
Completed by: _____________ _ Date: ______ _
FIGURE 7.1 A documentation review worksheet for real estate loans

Source: K. Pirok 1995, Managing Credit Department Functions: A Manager's Guide to Improving Loan
Analysis, Documentation and Reporting, Irwin, Chicago, pp. 142-3.
Specialrightsof lendingbankers
The law provides that lenders (lending bankers in particular) have special legal
rights regarding the customer, including banker's lien, the right to set-off and
the right to appropriate payments. We will consider each of these in the following
sections.
Banker's
lien
A lien signifies the right of the lender (creditor), in possession of the goods or
security of the debtor, to retain those goods/security until the debt is fully
repaid together with interest. Once the debt is satisfied, the right of lien is
extinguished and the property has to be returned to the owner. There are two
kinds of lien: particular and general. A particular lien arises when the property
can be retained by the lender (creditor) for only a particular debt. A general lien
entitles the lender to retain the property in respect of all indebtedness of the
owner. The lien can be exercised irrespective of the account in which the
amount may be due. Banker's lien is a general lien. Thus, if a debtor has secured
a loan by property in one account and there are dues outstanding from another
account, then even if the debtor settles the first account, the bank can retain the
lien over the property until the indebtedness in the second account is cleared.
Banker's lien has certain special features. It carries the right of sale and recoup-
ment of the property. A banker can sell the property in satisfaction of indebted-
ness without recourse to a court. As already stated above, banker's lien covers
all sums due and payable by a customer whether via loan, overdraft or other
credit facility. Banker's lien, however, does not attach to securities given for the
purpose of safe custody. Similarly, 'money paid into a bank account or a credit
balance can never be the subject of a lien' (Weerasooriya 1995, p. 318). A
common example of lien is a term deposit that a bank holds in respect of a cus-
tomer who has defaulted in repayment of a personal loan. The bank can use the
proceeds of the term deposit in satisfaction of the debt.
Therighttoset-offandtherighttoappropriate
payments
Set-off has the effect of combining the various accounts between the debtor and
the lender to arrive at the net balance payable to one another. The right to
set-off enables a bank to adjust wholly or partly a debit balance in a customer's
account with any balance lying at hislher credit. As a matter of abundant pre-
caution, some banks obtain a specific letter from the customer to the effect that
it can set-off the accounts of the customer.
In general, the customer paying the money has a right to specify to the bank
how the payment is to be appropriated - that is, to which account the pay-
ment is to be credited if the customer has multiple accounts. When such an
instruction has not been given, the lender has a right to appropriate the pay-
ment towards any of the debts owed by the customer to the bank.
Legalrequirements
specific
tohomeloans
The legal requirements set out in the above discussion generally apply to all
consumer loans. Regarding home loans, however, some specific legal terms
need to be explained. We will discuss these terms in the following sections.
Property
'Property' means anything that is owned or controlled. It can be real property,
such as land and buildings, or personal property (called chattels), such as furni-
ture and jewellery. Real property is immovable and personal property is mov-
able. Lenders regard landed property (land) as the best form of security. Land
possesses all the ideal characteristics of a security: land is easily identifiable;
title to property can be established; the value can be determined without much
difficulty; the value remains generally stable; and property can be easily sold.
Realestate
'Real estate' is described as the earth, the land and all permanently attached
natural and human-made hereditaments (Sirota 1994). Hereditaments are
things capable of being inherited. Land, streams, trees, minerals, buildings,
fences and other features permanently in place on land are interpreted as real
estate. It must be remembered, however, that things such as minerals belong to
the Crown and are not included in ownership of land.
'Title' is an abstract term that refers to documents, records or Acts that confer
ownership of property. When real estate is being purchased, the buyers must be
in a position to assess the quantity and quality of ownership rights that they are
220 Pari 3: Consumerlending I

acquiring. The banker and the borrower will be interested in assurance of title
of the real estate. Title assurance refers to the means by which buyers of real
estate (1) ensure their sellers have and can convey a clear title, and (2) receive
compensation if the title turns out to be otherwise. Title is usually conveyed
from one person to another by means of a written instrument called a deed.
Australia has two types of title (ownership) to the land: the traditional/old
(general law) system and the Torrens system (also called the registered system).
The Torrens system is an improvement over the 'old' system. As stated by Tyree
(1995, p. 362):
... a purchaser of land could obtain valid title only by having the land conveyed
by the true owner of the land. In order to determine that the seller was a true
owner, it was necessary to establish that the previous seller was the true owner
and so on right back to the original Crown grant.
If any deed or transfer was 'forged' in the chain of transfer of the title to the
land, then all subsequent titles to the land are defective. Such an investigation is
time consuming, expensive and uncertain, given that the title could come under
attack at a future date. Under the Torrens system, the ownership of each parcel
of land is recorded on a separate folio (page) of the central register kept at the
State capital. Transfer of title is effected by recording the name of the new
owner in the register. The State then issues a certificate of title based on the
records in the registry, which constitutes conclusive evidence that the person
stated therein is the owner of that parcel of land. Once such a certificate is
issued, it is not necessary for the registered owner to prove that previous trans-
fers were valid. The touchstone of the Torrens system is the indefeasibility of
title. 'Registration as the registered proprietor is conclusive evidence of owner-
ship subject only to certain exceptions related to a person who becomes a regis-
tered owner by means of his/her own fraud' (Tyree 1995, p. 363). As stated by
Weerasooriya (1998, p. 203), 'in some States both [Old and Torrens systems]
exist, whereas South Australia has only the Torrens system. Almost all private
lands in all the States are now covered by the Torrens system'.
Whenever land is taken as security, lenders should be aware about three types
of interest that may exist in the land under the Torrens system: registered inter-
ests, unregistered interests and other unregistered interests. Most interests in
land are registered interests. Registered interests have a priority over unregis-
tered interest, unless the unregistered interest is overriding. As stated above, the
indefeasibility of title is an advantage of the Torrens system from the viewpoint
of the lender. This means, if no fraud is involved, that the registered owner's
title is valid: that is, it is conclusive and not impeachable. Given this Simplified
system of registration of title, the Torrens system is considered as a boon by
bankers and customers alike.
A mortgage deed is the actual instrument by means of which a security is cre-
ated for a bank loan. We have discussed the features of a mortgage deed earlier.
Under the Torrens system, the mortgage takes the form of a statutory instru-
ment. After such an instrument is registered, the mortgagee (lender) acquires
interest in the security (land). According to Weerasooriya (1998, p. 212), this
interest 'carries with it most of the rights and obligations of a mortgagee under
the old system of mortgage'. Procedures exist to place the interest in real estate
on public record. Once an instrument creating a claim on the interest in real
estate has been duly recorded, the recording is deemed to give a constructive
notice of interest to the world.
Interestin realestate
There are basically two types of interest that one can hold in a property. An
interest (a bundle of rights) that has no time limit (permanent in nature) is
called a freehold interest in the property. An interest held for a limited or fixed
length of time is called a leasehold interest. The freehold interest in property
could be of various types. Fee simple interest is the highest bundle of rights
that a person may hold in real property. It can take the form of joint tenancy or
tenancy in common. Joint tenancy means any number of partners own an equal
and undivided interest in the property. This ownership type is generally limited
to family members; upon death of one of the partners, hislher interest is auto-
matically divided equally among the surviving partners. Tenancy in common
signifies that many partners may hold an undivided but not necessarily equal
share of interest in the property.
In leasehold property, the landlord gives up possession of real estate to a
tenant who acquires an equitable interest in the property according to the terms
and conditions of the lease. The ownership of the property remains with the
landlord (lessor), who transfers only the right to possess and use the property
for a limited period of time to the tenant (lessee). A common example is when
you rent an apartment: the landlord is the lessor and the tenant is the lessee.
The tenant can use the property but not sell it, because the property belongs to
the lessor.
Encumbrances
andliens
An encumbrance is a right or interest in a property held by one who is not the
legal owner of the property. Almost every parcel of real property has some form
of physical encumbrance imposed on it. Common examples are the utility encum-
brances for installation of water, gas, electricity and telephone services. These
physical encumbrances are attached to the property and become 'covenants' that
run with the land. Where the encumbrance is financial, it is called a lien. A lien
is a claim against a specific property wherein the property is made the security
for the repayment of a debt. A mortgage is an example of a financial encumbrance.
Foreclosure
Foreclosure gives the lender the right to become a full owner of the mortgaged
property in the event of the borrower's inability to repay the debt. All the rights
of the mortgagor in the property are extinguished and the mortgagee acquires
full rights of the property. Before a lender can foreclose on the property, it needs
to obtain a court order. Lenders find, however, that it is inconvenient to exercise

the right of foreclosure and run the property themselves. Assume that a bank
forecloses on a property (farm land) somewhere in Queensland; looking after the
property and using it to produce income could mean unnecessary responsibilities
for the bank, which it would like to avoid. The bank could perhaps lease the
property, but its objective is to settle the debt as early as possible. Instead of fore-
closure, therefore, banks can use the mortgage document's clause that gives it a
power to sell. This is an efficient way of recovering the dues. Further, in case
there is a shortfall, the bank still has rights to recover money from the borrower.
Statuteoflimitations
The duration of a relationship between a banker and customer is governed by
the statute of limitations, which specifies the time limit or period within which
a person may claim a legal remedy or redress. In the case of a simple contract
of debt (for example, a loan overdraft or personal guarantee) or an action
founded in tort (for example, an action against negligence), the period of limi-
tation is six years. The period of limitation varies among States; for mortgages,
for example, the statutory period is twelve years in New South Wales and
Queensland, fifteen years in Victoria and twenty years in other States. The
statutory period begins as soon as a breach of contract is committed. It can be
extended by a payment on account or written acknowledgement of debt. This
is the reason that lenders regularly obtain balance confirmation (acknowledge-
ment of debt) from customers.
Otherrelevantlegalrequirements
in lending
Here, we will discuss relevant legal aspects in lending that we have not already
covered.
Legalissuesaffectingoverdrafts
andcreditcards
An overdraft permits the customer to overdraw his/her account subject to the
limit approved. An overdraft is usually created in a current account and is the
most common form of short-term lending for businesses. Personal customers
may also be allowed overdraft limits. A customer is required to apply to the
bank for an overdraft limit. After assessing hislher creditworthiness, the bank
decides to approve the limit (say $10 000). The customer can operate the over-
draft account - that is, withdraw from and deposit into this account as and
when required - but debits are not allowed to exceed the limit fixed by the
bank. A credit card limit is akin to an overdraft limit.
If a customer draws a cheque and the balance in the account is insufficient to
pay the cheque, then the customer is considered to have requested an overdraft.
Banks usually contact the customer and bring this fact to his/her notice, and
then approve the payment. Banks charge a fee for doing this; for example, one
of the major Australian banks charges $20 whenever a personal customer draws
a cheque for an amount that exceeds the balance in the account. The customer
may also be charged interest for the period and on the amount by which the
account remained in debit. If the bank has approved a specific overdraft limit,
however, then it has to honour cheques drawn by the customer so long as the
balance is within limits. If a bank desires to cancel the overdraft limit approved
to a customer, then it should give prior notice to the customer to that effect.
Credit card transactions are governed by the Electronic Funds Transfer (EFT)
Code of Conduct. This voluntary code was introduced in December 1989. It
outlines the rights and obligations of the card users and the card issuers. The
Australian Payments System Board (previously the Australian Payments System
Council) monitors the compliance with the code.
Creditreferences
aboutcustomers
Banks are often reqUired to give credit opinions or credit references about their
customers. Such references need to be given in confidence and contain infor-
mation about the financial standing of the customer. Although giving a 'banker's
opinion' is part of the everyday business of banking, banks are exposed to
common law liability for giving a status opinion on customers. The bank has to
be very careful in drafting the 'opinion', which has to be based on facts; other-
wise, a customer who has suffered damage due to such a report may sue the bank.
A third party that has suffered a loss by relying on the incorrect opinion given
by the bank could also hold the bank liable. As quoted by Weerasooriya (1998,
p. 291), it was held in Hedley Byrne & Co Ltd v Heller & Partners Ltd (1964) that:
... the relationship between the customer who seeks a status report through his or
her own banker and the banker who supplies the report is a speCial relationship,
akin to a contractual or fidUCiary relationship. Therefore, the banker owes a duty
of care to the third party inquirer.
Undueinfluence,
duress,coercion
andcompulsion
in
banklending
Actions that constitute undue influence, duress or the like may arise, especially
in the context of recovery of loans but also in the lending process. There are
many cases in which lenders were taken to court over allegations of undue
influence, duress or the like. (For complete details, see Weerasooriya 1998.)
Here, we will provide an overview of these concepts.
'Undue influence' means unfair and improper conduct. It includes some coer-
cion from outside or some cheating, and is presumed to exist in relationshi.ps
between parent and child, physician and patient, religious/spi.ritual adviser and
diSCiple, and so on. In a banker-customer relationship, there is no such pre-
sumption. There is no fiduciary duty of care between banker and customer; it is
just an ordinary commercial relationship. Where bank staff have gone beyond
their standard practice, however, and provided advice to the customer about a
particular transaction, then undue influence can occur. Court cases before 1985
generally held that the banker-customer relationship was of the nature of fidu-
ciary duty of care, but the UK House of Lords subsequently halted this trend.
Duress, coercion and compulSion mean actual violence or threats of violence
to the personal safety or liberty of the other party. Cases against lenders
I 224 Pari3: Consumerlending I

generally fall in the category of economic duress or compulsion; examples have
included the withholding of money until a guarantee was executed, and a threat
to file a bankruptcy petition unless an overdue overdraft was settled. To protect
themselves against charges of economic duress, lenders normally require a bor-
rower to seek independent, adequate and complete advice about the trans-
action.
Anti-discrimination
law
This legislation prevents services (including financial services) from being
denied to anyone solely because the applicant belongs to a different religion,
sex, sexual orientation, race, age or nationality. It ensures everyone has the right
to a 'fair go', and discrimination, harassment and vilification are prohibited.
Anti-discrimination laws exist in all countries. In Australia, nine pieces of
Commonwealth legislation prohibit any form of discrimination and the States
have also enacted laws that prohibit discrimination. The Commonwealth legis-
lation includes the Affirmative Action (Equal Opportunity for Women) Act 1986,
the Disability Discrimination Act 1992, the Equal Employment Opportunity
(Commonwealth Authorities) Act 1987, the Human Rights and Equal Opportunity
Commission Act 1986, the Human Rights (Sexual Conduct) Act 1994, the Privacy
Act, the Racial Discrimination Act 1975, the Racial Hatred Act 1995 and the Sex
Discrimination Act 1984. The provisions of each of these Acts are beyond the
scope of this book, but it is sufficient to know that any form of discrimination
in the provision of goods and services is prohibited. Section 13 of the Racial
Discrimination Act, for example, states that:
It is unlawful for a person who supplies goods or services to the public or to any
section of the public: (a) to refuse or fail on demand to supply those goods or
services to another person; or (b) to refuse or fail on demand to supply those
goods or services to another person except on less favourable terms or conditions
than those upon or subject to which he or she would otherwise supply those
goods or services, by reason of the race, colour or national or ethnic origin of that
other person or of any relative or associate of that other person.
Table 7.1 shows the statistics of the top five (by grounds) of the total number
of enquiries received by the Anti-Discrimination Board of New South Wales.
TABLE 7.1 Total number of enquiries, by grounds, 2000-01
Grounds Number Shareof total (%j
Sex 2767 17
Disability 2002 12
Race 1569 10
Age 841 5
Homosexuality 315 2
Source: Anti-Discrimination Board of New South Wales 2002, www.lawlink.nsw.gov.au/adb.nsf/pages/

statsindex, accessed 14 March 2002.
As table 7.1 shows, most complaints are received on the grounds of sex and
disability discrimination. In the context of sexual orientation discrimination,
the following 'Industry insight' may be of interest.
Protection
'orhomosexuals
intheprovision
oflinlncillservices
Gay and lesbian festivals may be losing their shock value, but the amount of
corporate sponsorship these events attract could well become a new talking
point.
Financial institutions, ever-attuned to the opportunities offered by a lucrative
niche market, are recognising the attractions of the gay and lesbian sector with
its perceived high level of disposable income. Financial institutions, eager to
forsake the boring, conservative label, are developing campaigns to enhance
their 'gay appeal'.
Westpac is sponsoring specific gay events, such as the Gay Games that will be
held next year in Sydney. Until recently, Macquarie Bank sponsored Fruits in
Suits, a monthly get-together for members of the gay community. A Macquarie
spokeswoman says: 'The bank has always had a strong gay client base, but it
obviously doesn't differentiate between clients, and generally focuses on busi-
ness-related marketing initiatives. The bank felt the Fruits in Suits sponsorship
had run its natural course and that, in a marketing and sponsorship sense, the
gay community was being targeted through the bank's other marketing and
sponsorship initiatives'.
Not all financial institutions feel a need to market to people based on their
"lifestyles. 'Our marketing identifies groups such as the financially-savvy young
investor or retirees', Mike Smith, the media spokesman for AMP,says. 'We don't
market to people based on their lifestyles, rather we base it on their life stages.'
One financial institution that is a strong supporter of the gay and lesbian
community is Aussie Home Loans. It sponsors events such as the Gay and
Lesbian Film Festival and advertises in the gay press and backs the community
through donations to various causes. Managing director John Symond began
marketing to the community about four years ago.
'We realised the gay and lesbian community is a market of its own and are a
large and important part of our community', Mr Symond says. ; : " ".
'We looked at the needs of this community and said we can accommbdate
them. We believe that there are probably lots of banks and lending institutions<
that don't recognise gay and lesbians and felt we could be gay-friendly and
tailor our products to their needs. It is a very sensitive market and you can't just
ambush it with advertising.'
Aussie's approach appears to be effective as surveys have shown the
company to be top-of-mind as a home lender within the gay and lesbian
community.
I 226 Part 3: Consumerlending

been effective for
.
. right through our company.
. Iludlesbiau community, and this
they come in for a loan.'
at:)ntiiairn;the community at a grass-roots
the Gay and lesbian Film
Festival and donated to the Bobby Foundation as well as to the
Gay and lesbian Switchboard in Victoria and Queensland.
'We feel we have built up a rapport through giving something back to the
community', he S:;lYs.' 'This is more effective than just advertising in the gay
press.' /;': .
Alex Sosnov, as.ppkc;$woman with the Gay and lesbian Rights lobby says
there are severalfinmcial institutions, such as Aussie and Wizard, that are
marketing specifically to the gay community. 'This type of marketing is
effective beea:Ul?egays and lesbians know that they aren't going to be dis-
criminatedagii:nS£:if.they go to these institutions for home loans or insur-
we tend to find with financial institutions are subtle
For example, if you and your (same-sex) partner
a loan, you might be discriminated against through
who you are seeing. (There's) anecdotal evidence
(jf'thiiigs iikeapplications going missing or being given a hard time about
marital status.'
Taking out insurance or a home loan can be difficult for a gay person.
With insurance, for example, a gay person is subjected to much more
rigorous questioning than a heterosexual one, Ms Sosnov says. 'If you are
gay and not HIV-positive for example, you will still have to undertake a
HIV test.
'Gays and lesbians still find it very hard to deal with
each time they apply for something they have to answer
marital status or joint ownership', she says. 'You basically have to come
about your sexuality each time you apply. When you know there is an organ-
isation that when you mention two women's or men's names, they are not
going to blink or ask further questions, you will go with them because they
make everyday life easier.'
Source: G. Bryant 2001, 'Banking on a gay mood',. The Age, 13 August, p. 6.
TheBankruptcy
Act
The modern law of bankruptcy.works on two principles. The law provides a
method for the equitable distribution of the estate of a person who is hopelessly
insolvent. It also provides for a release of the debtor from their debts and obli-
gations, and allows the bankrupt to make a clean start. Simply stated, an insol-
vent is a person who is unable to pay hislher debts as they fall due. There are
two ways in which an individual can become bankrupt: (1) a debtor may
present hislher own pennon to the Bankrupty Registrar and, upon approval
thereof, he/she will be declared bankrupt; or (2) creditors may present a
petition. Lending officers should be careful in expressing a view about the like-
lihood of the customer becoming bankrupt. The customer can bring a civil
action against the bank for defamation.
Environmental
issuesandlendinginstitutions
Environmental law matters may arise before or after a financing decision has
been made. Blay and Clark (1993) identify four areas of risk for financial
institutions in the context of environmental law: regulatory compliance risk;
the risk of clean-up liability; the risk of liability for compensatory damages to
injured parties; and the risk of criminal liability. Given an increasing trend
towards allowing environmental considerations to override commercial and
business considerations, the implications of violating environmental law could
be both complicated and onerous for lending institutions.
Codeof Banking
Practice
The Australian Bankers Association published the Code of Banking Practice
in November 1993. The adoption of this code is voluntary, but most banks in
Australia have adopted it. The objectives of the code are to foster good
relations between banks and their customers, and to promote good banking
practice. The code, which is monitored by the Australian Securities and
Investments Commission, requires that the bank make certain disclosures to
customers as set out in its various sections. The self-regulatory code sets out
standards of disclosure and conduct which subscribing banks agree to observe
when dealing with their customers. The standards cover matters such as the
terms and conditions of bank accounts, the disclosure of fees and charges,
privacy, confidentiality and how to resolve disputes.
The Australian Bankers Association released an independent review of the
code in 2002. This is the first review of the code since its publication in
November 1993. The review was undertaken to take account of changes in the
banking services market and in the needs and behaviours of customers as a
whole. Details about the review could be found at the Australian Bankers
Association website (www.bankers.asn.au).
Australian
Banking
Industry
Ombudsman
The Australian Banking Industry Ombudsman is an authority for the resol-
ution of disputes between customers and their banks. The ombudsman is
appointed by the industry. The majority of the complaints received by the
ombudsman relate to housing (fixed and variable rate home loans and
investment property loans) and consumer finance (credit cards, personal
loans, equity finance, personal overdraft). The complaints generally relate to
excessive, inappropriate or wrong fees, a delay in loan approvals, the
charging of wrong interest rates, the wrong calculation of repayments and
interest, and a misunderstanding about loan repayment terms or security.

Table 7.2 shows the breakdown of complaints received by the ombudsman
by the type of financial service.
TABLE 7.2 Product groups identified in complaints, 2001 (Total product registrations = 4987)
Productgroup Shareoftotal (%)
Consumer finance 25.3
Deposit accounts 22.6
Housing finance 21.7
Payment systems 16.9
Business finance 10.0
Other products 3.5
Source: Australian Banking Industry Ombudsman 2002,

accessed 14 March 2002.
As shown in the above table, consumer finance and home finance are in the
top three products about which the Banking Industry Ombudsman receives
complaints.
A Credit Union's Dispute Resolution Centre was established in November
1996. The centre has 160 credit union members. Its complaints-handling
procedures are managed by the Banking Industry Ombudsman. The centre
resolves consumer complaints against a credit union.
Australian
Securities
andInvestments
Commission
The Australian Securities and Investments Commission (ASIC) Act 1989
empowers the commission to monitor and promote market integrity and con-
sumer protection in relation to the Australian financial system and the pay-
ments system. The commission administers the regulatory system of consumer
protection, among others, for depOSit-taking activities. It does not have con-
sumer protection responsibilities for credit, because those responsibilities
belong to the Australian Competition and Consumer Commission. The Finan-
cial Services Reform Act 2001 gives the Australian Securities and Investments
Commission consumer protection responsibilities for credit and foreign
exchange contracts.
The main objective of the Act is to raise the standard of service delivered by
financial services providers to their consumers. In this context, the Act
requires that all financial services providers satisfy the Australian Securities
and Investments Commission in terms of compliance arrangements. Unless
they maintain a standard of compliance, financial services providers may find
it hard to hold a licence.
Staftabuse
ofnewlending
business
incentives
inANIbank
The chairman of the Australian Securities and Investments Commission
(ASIC), Mr David Knott, today announced that ANZ Bank has appointed an
external consultant to review staff incentive practices within the General
Banking Unit of the Bank.
On 8 November 2000, ASIC announced that it was conducting an enquiry
into the sales-driven remuneration practices and policies of ANZ Bank,
following the leak of an internal ANZ Bank memorandum in October 2000.
Mr Knott said that, following initial enquiries by ASIC, the bank has
appointed PricewaterhouseCoopers to address these issues, with a view to
reporting its findings 10 ASIC within the first quarter of 2001.
'Our own investigations to date have not revealed any product mis-selling or
direct evidence of customer financial loss. However, there is some evidence of
isolated staff abuse of new lending business incentives and we need to fully
understand the impact which these practices have had on bank customers', Mr
Knott said.
'We believe that a comprehensive external review of these matters is the best
way for ensuring that all aspects of this incentive scheme are fully and inde-
pendently scrutinised. We are satisfied that PricewaterhouseCoopers has the
necessary terms of reference to perform that work.
'Inthe meantime, we welcome the commitment of the bank to address any
identified shortcomings in its incentive practices. The bank has committed to
ensure that any financial loss incurred by customers is fully compensated,
which we regard as appropriate', said Mr Knott.
Mr Knott added that ASIC will monitor the external review and reserves the
right to take additional action if warranted.
Source: Australian Securities and Investments Commission 2000, 'ANZ Bank appoints consultant to
review incentive practices following ASIC inquiry', Media release, 20 December.
Checklist
forlendingofficers
While no-one expects a lending officer to be a legal expert and know the finer
details of law, some basic knowledge of the legal aspects of lending would be
desirable. Given the complexities of legal requirements, we present here a
simple checklist (although not exhaustive) that could help a lending officer.
I. Ensure the prospective borrower has capacity to contract: that is, the bor-
rower is a major, a person of sound mind and not an insolvent. Obtain
copies of the borrower's driver's licence and other identity documents,
check them against the originals, and authenticate the copies by signing
them and affiXing the stamp of the bank.
2. Ensure the prospective borrower's consent has been obtained as required
under privacy laws.

3. Ensure compliance with the provisions of the Uniform Consumer Credit
Code as explained earlier.
4. Ensure required documents (such as the promissory note, mortgagee deed
and guarantees, are obtained.
5. In the case of mortgages, ensure the borrower has a valid title to the prop-
erty by examining the original title deed. It is also important to ensure the
property does not carry any encumbrances. These matters are usually
taken care of by solicitors appointed by the bank. The solicitors carry a
search on the property and submit a search report, which must be kept on
the record.
6. Where the property is leasehold, examine the original lease deed in favour
of the borrower to ascertain the unexpired period of the lease. Examine the
terms and conditions of the lease and rent receipts.
7. Ask the borrower to produce receipts that show that local council dues and
other statutory dues have been paid up to date.
S. Ensure a valuer's report on the property is obtained and held on record.
9. Execute (date and sign) all legal documents in the presence of an author-
ised bank officer, who should authenticate the signatures of the executants
and put a seal of the bank on the documents to that effect.
10. Ensure all executed documents are securely stored and held in the custody
of the bank while the debt is pending. The security documents should not
be parted with under any circumstances, because such a course of action is
fraught with grave risks.
11. Wherever a document requires witnessing, ensure it is witnessed.
12. Ensure all parties authenticate any alterations or modifications made in the
document. Once documents are signed and sealed, do not allow further
alterations to the documents without the full knowledge and consent of the
borrower and guarantor.
13. Verify all documents against their originals and suitably authenticate.
14. Ensure suitable stamp duty is paid where documents require the payment
of stamp duty.
15. Where the debt is still outstanding, ensure documents are renewed in
time so as to avoid the expiry of documents due to the application of the
law of limitations. Law courts may not admit expired documents as valid
evidence if legal action is subsequently deemed necessary in an overdue
loan.
16. Disburse no loan unless all the relevant documents are duly completed and
Signed by the borrower.
17. Ensure standard practice is followed while answering queries of the
customer. The borrower should be advised to obtain independent legal
opinion from his/her solicitors about the implications of signing the
documents, and the bank should keep on record a declaration to the
effect that the borrower understands the provisions of the clauses in
the documents.
Service One Credit Union is recently formed and operates the business of three
credit unions (The Credit Union of Canberra, Snowy Mountains Credit Union
and Hospitals Credit Union).
Pre-contractural disclosure
Each member receives pre-contractual disclosure documents before submitting
a loan application. These documents include:
• general descriptive information regarding loans, personal cheques, payment
services, the operation of accounts and a schedule of fees and charges
• an information statement - things to know about a loan contract
• loan repayment insurance information
• an interest rate brochure.
Assessing and processing a personal loan

1. Process summary
A loan application that has been submitted for assessment is subject to a
number of policy checks in Decision Point (a loan origination system). This
assessment process forms the loan assessment procedure. As well as making
judgements with regard to policy failure, further external assessment tasks
must be completed. If any data are changed that will affect the financials of
the application during this procedure (interest rate tier or income infor-
mation, for example), the loan must be cancelled and a new application must
be completed and submitted.
The loans officer performs the following procedure when a personal loan
application has been submitted to Decision Point and requires assessment.
2. Process detail
2.0 Access the Queue Manager in Decision Point and ascertain what stage
the application has reached.
2.1 Check that the application has been completed correctly. Decision Point
is an approval-based system, so all information on the applicant's
liabilities and assets must be fully completed before submitting the
application for approval.
2.2 Has the application been completed correctly? Check that the Valuations/
Exposure fields hold all current Credit Union commitment values. This
is used for delegated lending authority limits. All liabilities must have a
repayment, frequency and outstanding balance.
No Continue
Yes Go to 2.5
2.3 Edit the application as required.
2.4 Save the changes to the application and continue.

2.5
Yes ;) Continkle
2.6 Complete t.h.e:si:eps
required for the particular policy failure as per
All scenarios for policy failure are addressed in
.•.
2.7 Has the:;appljcatlon failed another policy check?
No
Yes
2.8 Are credit required?
No Go toiU
Yes Continue
2.9 For each recent enquiry that appears on the Credit Advantage rq>olltH\;.;:i
contact the institution involved to obtain the status of the loan.
list of institutions that will not provide references, refer to the loan
assessment policy.)
2.10 For each current external loan appearing on the loan application, obtain
credit references as per procedure. (For institutions that will not pro-
vide references, refer to the loan assessm olicy for detail.)
2.ll Is the application outside your delegated. ,authority for
1'\ ....
approval? When assessing whether a your ••"
lending authority, loan aggregation must be taken into account.

No Continue
Yes Go to 2.14
2.12 Is the loan suitable for notional approval?
No ;) Go to 2.20
Yes Continue
2.13 Complete notional approval and check the application back into the
queue as per system standard.
Go to 2.21
2.14 Is there an officer within the branch with the appropriate delegated
lending authority?
No Go to 2.16
Yes Continue
....:!.15Transfer the application to the officer with the appropriate delegated
lending authority as per system standard. The officer who has the
appropriate delegated lending authority will be required to notion-
ally approve or decline the application, and transfer the application
back to the originating officer to complete the processing of the
application.
Go to 2.18
(continued)
2.16 Prepare a submission (recommendation for approval) and fax to Loans
Administration. A recommendation for approval submission must be
completed for all loan applications being referred to a delegated lending
authority outside the branch.
2.17 Transfer the application to Loans Administration for notional approval
as per system standard.
2.18 The delegated officer must either notionally approve or decline the loan
and transfer the application back to the originating officer to complete
the processing of the application. Wait for the application to appear
back in Queue Manager of Decision Point.
2.19 Is the loan notionally approved?
N0 Continue
Yes Go to 2.21
2.20 Decline the application as per procedure.
Go to 2.27
2.21 Is the loan approval subject to conditions?
No Go to 2.23
Yes Continue
2.22 Advise the applicant verbally that the loan is approved in principle, sub-
ject to conditions. Arrange for the applicant to meet the conditions.
Go to 2.24
2.23 Advise the applicant verbally that the loan has been approved.
2.24 Does the applicant wish to proceed with the application?
No Continue
Yes Go to 2.26
2.25 Cancel the application as per procedure.
:) Go to 2.27
2.26 Finalise the application as per procedure.
2.27 End.
Source: Mr Peter Carlin, Chief Executive, The Credit Union of Canberra, Australian Capital Territory.
Summary
1. What legal framework governs consumer and real estate lending?
The legal framework that governs consumer and real estate lending has two
aspects: first, the legal requirements that need to be met before a loan con-
tract is entered into and, second, the legal requirements to be met after a loan
contract is signed. Twelve different areas of legislation affect the lending
activities of financial institutions in Australia.
2. What lending documents need to be obtained in consumer and real estate
lending? What is the purpose of each of these documents?
• A promissory note is a basic acknowledgement of debt.
• A mortgage deed the security to the lender.

• A letter of guarantee is a legal undertaking on the part of the guarantor to
repay the debt together with interest if the principal borrower fails to
repay.
• A bill of sale is evidence of purchase of an asset.
• Assignment of shares or life policies acts as collateral in the event of non-
repayment of the loan.
• A loan agreement is a basic loan contract setting out the terms and con-
ditions of the loan.
3. What are the special legal rights of lending bankers?
The law provides that lenders (lending bankers in particular) have special
legal rights regarding the customer. These include banker's lien, the right to
set-off and the right to appropriate payments.
4. What legal requirements are specific to home loans?
The legal matters that are specific to home loans are types of interest in real
estate, encumbrances and liens, foreclosures and the statute of limitations.
5. What are the other relevant legal aspects in bank lending?
• A lien signifies the right of the lender (creditor), in possession of the
goods or security of the debtor, to retain those goods/security until the
debt is fully repaid together with interest.
• The right to set-off enables a bank to adjust wholly or partially a debit
balance in a customer's account with any balance in his/her credit.
• The lender has a right to appropriate the payment towards any of the debts
owed by the customer to the bank if specific instructions for appropriation
have not been given.
6. How is a checklist used by lending officers to ensure the fundamental legal
requirements of lending are satisfied?
A lending officer has to ensure that: a prospective borrower has capacity to
contract and has given consent under the Privacy Act; provisions of the
Uniform Consumer Credit Code are met; all required documents are signed;
and the borrower has a valid title to property. There are also a few other
requirements detailed above under the relevant sections.
ad valorem, p. 216 fee Simple interest, p. 222 ombudsman, p. 228

assignment, p. 213 foreclosure, p. 222 promiSSOrynote, p. 213
banker's lien, p. 219 freehold interest, p. 222 right to set-off, p. 219
continuing guarantee, guarantee, p. 210 specific guarantee, p. 213
p.213 insolvent, p. 207 tenancy in common,
duress, p. 224 leasehold interest, p. 222 p. 222
encumbrance, p. 222 lien, p. 222 Torrens mortgage, p. 213
equitable mortgage, minor, p. 207
p.213 mortgage deed, p. 213
Discussion
questions
1. What are the various legal aspects that a lending officer must take into
account before a consumer loan is approved?
2. What are the important provisions of the Uniform Consumer Credit
Code?
3. Does the code provide for criminal penalties on lending officers?
4. What is unconscionable conduct? How is it different from deceptive
conduct?
5. Who administers the Trade Practices Act in Australia? What are the
important provisions of this Act that a lending officer should consider?
6. 'Banker's lien is a general lien.' Do you agree with this statement? How
does banker's lien help the banker in recovering dues?
7. What legislation enacted by the Commonwealth Government seeks to
prohibit discrimination?
8. Explain the salient features of the Australian Banking Industry
Ombudsman's role.
9. Does the Australian Securities and Investments Commission have any
role in protecting consumers in credit transactions?
10. What important points should a lending officer bear in mind for con-
sumer lending?
References
andfurtherreading
Blay, S. & Clark, E. 1993, Australian Law of Financial Institutions, Harcourt Brace,
Sydney.
Brueggeman, W. B. & Fisher, J. D. 1993, Real Estate Finance and Investments, Irwin,
Homewood, Illinois.
Cade, E. 1997, Managing Banking Risks, Gresham Books, Woodhead.
Caouette J. B., Altman, E. I. & Narayanan, P. 1998, Managing Credit Risk: The Next
Committee on Banking and Financial Services 1996, Consumer Debt, US House of
Representatives, Congressional Information Service, Bethesda.
Duggan, A. & Lanyon, E. 1999, Consumer Credit Law, Butterworths, Sydney.
Evans, D. S. & Schmalensee, R. 1999, Paying with Plastic: The Digital Revolution in
Buying and Borrowing, MIT Press, Cambridge, Massachusetts.
Fischer, W. C. & Massey, A. 1994, Consumer Credit in North Queensland, James
Cook University, Townsville.
Francis, E. 1987, The Law and Practice in All States of Australia Relating to
Mortgages and Securities for the Payment of Money, Butterworths, Sydney.
Grady, B. 1995, Credit Card Marketing, John Wiley & Sons, New York.
Hempel, G. H., Simonson, D. G. & Coleman, A. B. 1994, Bank Management Text and
Cases, John Wiley & Sons, New York.
236 Part3: Consumer

lending I
Hogan, w.,Avram, K. J., Brown, C., Ralston, D., Skully, M., Hempel, G. & Simonson, D.
Koch, T. W. 1992, Bank Management, Dryden Press, Forth Worth.
Kolb, R. W. 1992, The Commercial Bank Management Reader, Kolb Publishing,
Miami.
Nelson, G. S. & Whitman, D. A. 1981, Real Estate Transfer, Finance and
Development, 2nd edn, West Publishing, St Paul, Minnesota.
Reed, E. W. & Gill, E. K. 1989, Commercial Banking, Prentice-Hall, Englewood Cliffs,
New Jersey.
Sirota, D. 1994, Essentials of Real Estate Finance, Real Estate Education Company,
Chicago.
Tyree, A. 1995, Banking Law in Australia, Butterworths, Sydney.
Visa International 2000, Changing the Way We Pay: A Report on the Development of
the Payment Industry in the Asia-Pacific Region, Singapore.
Wallis Report 1997, Financial System Inquiry Final Report, AGPS, Canberra.
Walters, A. 1991, Corporate Credit Analysis, Euro Money Publications, London.
Weaver, P. M. & Shanahan, K. M. 1994, Banking and Lending Practice, Serendip,
Sydney.
Weerasooriya, W. S. 1998, Bank Lending and Securities in Australia, Butterworths,
Sydney.
Introduction
Corporate lending is an intuitive process that is more an art than a science at
this stage of its evolution. Credit scoring techniques are fast being developed
and applied to corporate lending, however, and are set to add a layer of protec-
tion over the approval process. The side effect of credit scoring is the accept-
ance that a percentage of loans will go bad; in the past, loans did go bad but
would not have been approved unless the analysis indicated the ability to repay.
In this chapter, we will examine the principles of corporate lending and their
application in the construction of corporate loans. In addition, we will examine
the actions of the loan officers in line with the success or failure of the loan pro-
cess. Within this process, we will examine the lifecycle of a loan to demonstrate
the difference between the products of a financial institution and those of other
corporate entities.
Anoverviewofcorporate
lending
Corporate lending represents the high end of the loan portfolio mix for a
modern bank or financial institution. It is also a fiercely competitive arena
where margins can be small and the risks can be great; a successful lender
understands the overall market and its niche in that market. Careful consid-
eration needs to be given to the type of client, and their reputation and
standing; the selection of a carefully balanced book ensures prosperity in the
good times and survival in the bad times.
The correct mix and share of various industries is essential to overall success.
Too much market share in one segment of the economy makes the institution
vulnerable to movements in the economy; in other words, a successful bank
sometimes declines good business so as not to be overexposed in a particular
market segment.
A good lender needs to balance the requirement to meet their target against
the quality of the business they write. The hallmark of a successful lender is the
ability to say 'no' to a bad or suspect proposition. One of the most important of
the many rules of lending is not to lend for the sake of lending. The approval
process should be in line with the lending criteria of the institution and the
individual's common sense. Loan quality is the essence of good management of
the loan portfolio.
The importance of loan generation and the credit competence of the
approving officers cannot be overemphasised. The structural changes and the
reliance on technology in the finance industry could send a signal of the relative
unimportance of credit approval, but the growth of a loan book involves risk,
which involves accountability, which introduces the need for education. A suc-
cessful loan officer understands the principles of lending and that segmenta-
tion in the marketplace allows for an expertise to be gained - in this case, in
the area of corporate lending.
Nobody can get it right all the time. A lender who claims to never have been
involved in a loss has probably never effectively and profitably lent money. The
I 242 Part4: Corporateandbusinesslending I

major reason for this risk is timing: lenders are using today's information to pre-
dict behaviour into the future. It is an inexact science at best; at worst, it is
about a most unpredictable form of human activity. The lender assesses the via-
bility of a particular borrower for a set amount for a given purpose over a
pre-determined period of time at a particular cost or interest rate, accounting
for known facts and predicting those facts into the future or making decisions
in a context of uncertainty.
Two major methods are used to facilitate the approval process in corporate
lending: 0) the traditional or knowledge-based approach and (2) the credit
scoring or statistical method. The skill of lending is to know when to accept
the risk; but first the able banker must be able to evaluate, assess and trust
that risk (Mather 1972). Flexibility is a key ingredient for success. To apply
basic principles as inviolate rules will mean good business is declined or the
special needs of an existing customer are ignored, to the detriment of both
the loan book and the success of the financial institution in the medium to
long term.
Thepurpose
ofcorporate
lending
Success is based on the premise that each party to the transaction has confi-
dence that the other will honour the terms of the agreement. The lender's pri-
mary purpose is to ensure the growth of the loan book in a quality way, so as to
make profits that ensure shareholder value is maximised in the long term.
Given that financial institutions deal in intangible assets, it is important to
recognise the hidden costs of loan approval and management so true value is
obtained via a properly researched and constructed loan policy.
Theloanportfolio
The creation of the loan portfolio is a key success factor for a successful finan-
cial institution. Lenders need to ensure the structure of their loan portfolio
demonstrates assets with varying interest rates, cashflows and maturities -
that is, a mixture of fixed, floating, interest only and at-call. The major consid-
erations in the construction of the loan portfolio are:
• asset mix and loan types
• diversification, to ensure the management of loan runoffs and therefore
protect the institution's internal cashflows
• geographic limits, which must be within the capability of the institution and
sufficiently diverse to allow a good balance of business
• expertise. To enter a defined market segment, a financial institution must
have staff that understands the market segment. Failure to address this issue
will result in an inability to generate positive income from the business.
• policy formulation, involving a correctly documented and articulated loan
policy to ensure direction is maintained
• environmental issues, focusing on economic activity, demographic information,
income and spending/expense profiles
• a competitive environment, which the lender recognises by gIvmg its loan
officers information about competitors and their structures, pricing policies
and management. This information will allow loan officers to predict
competitor reactions to initiatives.
• delegation, which must be clearly articulated so lending officers know the
limits of sustainable activity and the likely reaction time
• audit and review, which are key success factors in providing the hindsight
necessary to grow and develop corporate memory and culture.
Finally, in assessing the worth and sustainability of the loan portfolio, it must
be remembered that risk is the basis of return and must be considered in the
construction of the portfolio. Risk is a function of the cashflow relationship
between a portfolio's assets and its liabilities; that relationship is the key to the
profitability in relation to exposure of the loan book.
Theprinciples
ofcorporate
lending
There is an element of risk with every corporate loan application. Some risks are
apparent at the start of the transaction, while some underlying risks may occur
later and are not immediately obvious. Business development can become a key
driver as long as there is a conscious acceptance of increased risk. Unfortunately,
there are no rules for risk-free or trouble-free corporate lending, although
adherence to well-researched principles and practice will lessen the potential for
disaster and ensure, as a minimum, a disciplined approach to corporate lending
growth. A successful lender is able to identify the risks involved in a lending
transaction and assess those risks to decide whether they are acceptable and
they contribute to statement of financial position quality and growth. A lending
officer must ensure the safety and security of the financial institutions; at the
same time, he/she must manage uncertainty The future is unknown and the risk
of the portfolio needs to be managed. A safe loan book is potentially an unpro-
fitable loan book in a corporate sense. The one unalterable rule of lending to the
corporate sector is known as hurt money This rule states that the resources of
the borrower are the first tranche of funding; the lender advances funds only
after the first tranche is fully committed or spent. This funding sequence
ensures the borrower has an investment in the business or project and thus is
committed to the success of the venture. An examination of project failures will
demonstrate to the loan officer the peril incurred in ignoring this rule.
The following are the three overarching principles of corporate lending:
1. Safety. This principle looks at the ability to repay the loan - that is,
whether acceptable security, a satisfactory financial position and essential
personal elements exist.
2. Suitability. This principle looks at the lending policy of the institution, the
purpose of the loan, the amount of the loan, the amount of hurt money (or
the contribution by the borrower), and the repayment schedule.
3. Profitability. This principle looks at the collateral advantage to the insti-
tution and the return on investment.
244 Part4: Corporateandbusinesslending

By adhering to the above principles, the financial institution ensures, as far as
possible, the loan is in accordance with the doctrine, can be repaid and contrib-
utes to the overall growth in line with expectations.
A corporate loan is given on the expectation of repayment in full over the
agreed period of time. A wise lender, however, will ensure there are at least
three ways out of a loan.
1. The only true repayment of a loan is where the borrower fully complies with
the loan agreement and fully repays the loan.
2. If the loan is not repaid and is in breach of the covenants, then the lender
can activate liens over physical security and initiate the recovery process.
3. If the loan defaults and the physical security is either exhausted or does not
exist, then the lender targets the intangible assets of the business to realise
their value.
It is important to note here that only the first way guarantees that the finan-
cial institution will recover its investment along with its return. The second and
third ways may result in substantial losses if the security valuations are prob-
lematic or out of date.
Methodsoflendingassessment
There are many differing methods of assessing the extension of corporate facil-
ities. Different lending institutions use different methods and require adherence
to set criteria that reflect the corporate culture of the institution. Chief amongst
these criteria are the five Cs - a method of remembering the five key factors of
loan approval- and PARSER (a made-up word that reflects a slightly different
method for analysis and approval of corporate loans - see page llS). It is
important to realise, whatever the method chosen, that the aim is to confirm the
safety, sUitability and profitability of the applicant and whether the proposal fits
the risk profile of the institution.
The five Cs approach seeks to direct the enquirer to the key aspects of the
loan proposal. (It has several variants, including the three Cs.) The major weak-
ness of this method is that it does not formally point the analyst to the reason
for the loan.
• Character. The importance of assessing the character of a corporate cannot be
overstated. Specific attention should be paid to the history of the company,
how was it set up and by whom, the stakeholders, the organisation's
structure and accountability through the organisation. What are the products
that the company manufactures or accesses? Have they changed over time?
If so, what effect have the changes had on the organisation? What is the
reputation of the entity? (Reputation is a Significant goodwill factor in the
valuation of companies. It is seen as the greatest risk faced by a modern
corporate.) How does the company manage the value of its reputation and is
it growing over time? What is the record of management? What is their
combined expertise? Does management foster a good relationship with the
financial institution? All these factors allow for detailed analysis of a
potential borrower and its character. A company builds a personality over
time. The question is whether the identified personalty is one that the
financial institution would deal with as a lender.
• Capacity. A lender should be interested in not just the ability of the
corporation to repay a loan but also the ability of the corporation to borrow.
Company records or incorporation deeds are essential to ensure the
corporate entity has the ability to commit to any future transactions.
• Collateral. This refers to anything that is promised or deposited in support of
a loan and that the lender has taken a charge over - that is, security.
Security fulfils two basic needs for a lender: first, to ensure the borrower's full
commitment to the project and, second, to provide a second or third way out
for the lender in time of need (as discussed on page 245).
• Conditions. These indicate the future potential problems that may have an
impact on the business. Conditions can be external (those over which the
corporate has little or no control) or internal (those over which the business
has full control).
• Capital. An indicator of financial strength, capital can be demonstrated by
careful analysis of the company's financials. The capital contribution from the
corporate comes from its shareholder equity (the hurt money). In lending
terms, hurt money represents the borrower's contribution before the lender
makes a contribution. Care should be taken if the tax component of the loan
is necessary for approval of the faCility.
The PARSER method allows a staged approach to the analysis of six areas of
interest. Importantly, it identifies the purpose of the loan.
• Personal element. The characteristics of the corporate are analysed from a
cultural and ethical viewpoint. Prime areas for consideration are the
determination of the company to repay the debt, as shown by the integrity of
the board/senior management and its reflection in the corporate culture. The
asset position of the company and its track record in managing events for
positive outcomes will demonstrate the company's business ability in line
with its experience and spread of business. Lastly, the personal element
identifies the borrower's position and standing in the business community.
• Amount reqUired. What is the purpose of the loan? Is the amount requested
sufficient for the achievement of the purpose? Correct analysis ensures the
suffiCiency of the advance in relationship to the turnover, and identifies links
of need within the business.
• Repayment. The repayment of the loan cannot be problematic; in other
words, it should not be based solely on the cashflows of the transaction.
Consideration needs to be given to how much is required, when the money
will be needed, and from what source the lender can expect to be repaid. The
lender must hold current financials that demonstrate the effect of the loan on
the entity. This will involve trend analysis, detailed cashflow projections and
the determination of repayment options available to the lender. Finally, the
lender needs to be comfortable with the amount of the advance in relation to
the total turnover of the company.
246 Part4: Corporateandbusinesslending I

• Security. This represents the second and third ways out for a lender. It is
important to accept, however, that security does not guarantee the ability to
repay but rather the ability to support. A strong understanding of the type of
security, either tangible or intangible, and the sufficiency of cover ensures the
strong management of the facility. Total security may depend on the
saleability of specialised security and the recording of second mortgages,
especially over vacant or undeveloped land.
• Expedience. This represents the business opportunity for the lending
institution. What is the suitability of the transaction for the lender? What is
the lender's capacity to allocate funds from the available pool. Is the loan
being provided in a target market segment where the lender has capacity in
the portfolio for growth? Can other corporate business, credit facilities and
international business be gained from the provision of this particular
request?
• Remuneration. How profitable is the loan? Is it good for the institution and
does it fit the loan criteria as laid down by the credit committee? Has the
loan been correctly priced in terms of the interest rate, application fee and
commitment fees? Does the acceptance fee and customer profitability
analysis demonstrate the viability of the transaction?
Thelendingcycle
The lending cycle (figure 8.1, page 248) follows a loan from birth to death
- that is, from approval to repayment. Personnel involved in lending must
understand that the moment a loan is approved is the beginning of the
transaction, not the end. This is the key differentiating factor of a financial
institution from other forms of corporate entities. In most cases, the sale by
a corporate is the end of the transaction and the asset is converted into cash
or, at worst, a debtor's list for a short period of time and then into cash. At
the moment of asset creation by a financial institution, however, a series of
cash flows is created over the life of the loan.
In a strong marketing environment with a structured segmentation of
duties, the asset creation process and lifecycle can be overlooked. The sale of
the loan is seen as the end of the process, with the management of a loan
being an entirely separate issue. This lack of transferred ownership can lead
to a lowering of loan quality in the corporate book if not formally managed
by policy. A loan consists of three fundamentally different activities which
can be managed separately or collectively. In today's financial arena, there is
a strong separation of duties at the functional level. A successful corporate
lender, however, manages the activities collectively in at least a policy sense.
The three activities are:
l. origination
2. funding
3. managing.
:!!'f_. _
(a) The lending cycle
Target markets Origin Evaluation
Documentation Approval "

Negotiation
"
Disbursement Administration
Orderly payment Unforeseen events
Repayment Loss
Workout situation
Write-off
(b) A model of the commercial lending decision-making process

Start
y
r
Evaluate the potential of a
new customer relationship.
Is the firm No Determine the credit needs of
a present customer -. the customer (purpose of loan,
amount, maturity).
of the bank?
yYes Investigate creditworthiness of

the proposed loan by analysing
Yes
Is Check loan application against the firm's:
an extensive No . . - • quality of finanCial information
legal and policy restrictions.
credit check on the firm • economic characteristics (size,
"
required? market share, diversification)
• competitive position in industry
+
Loan monitoring process
• Timing of payments
Should loan
be recommended?
• financial characteristics
(profitability, liquidity, leverage,
growth)
• Value of collateral • management (quality,
• Compliance with covenants " Yes experience, depth)
Recommendations concerning
••
• Periodic financial reports • availability of funds (equity or
terms of the loan (type of debt markets)
financing, amount, interest rate, • ability to repay loan (cashflow
End collateral, covenants, repayment)
y analysis, security)
• supplier experience
Record analyses Loan committee approval • experience at previous bank
• value of collateral
and recommendations.
t
•
FIGURE 8.1 The lending cycle
Completed documentation file
and determine a credit risk score.
Source: M. J. Shaw & J. A. Gentry 1988, 'Using an expert system with inductive learning to evaluate
business loans', Financial Management, 17, p.47.
I 248 Part 4: Corporateandbusinesslending I

Knowledge of the formal lending cycle is essential to the ongoing success of
a financial institution and the overall profitability of the corporate loan port-
folio. The cycle consists of the following series of activities that ensure the loan
is managed from origination to payment:
• Identification and exploitation of target markets is the planning phase of the
loan process. Here, the lender defines a strategy for selling and ensures its
products are accessible to the identified segments. Success at this stage
depends on the competence of the staff that are planning and forecasting the
potential of the institution and its product mix.
• The success of origination of loans depends on the ability of the lender to
find clients and meet their expectations. Some institutions rely on financial
brokers to introduce a proportion of the business for a fee.
• The credit analysis or evaluation stage involves formal evaluation. The
purpose of the loan, to whom it is to be advanced and the management
competencies are key factors for analysis. The financial information is the
basis on which the lender feels reassured.
• The negotiation stage is the key stage, because the lender can impose its will
regarding terms and conditions. Remember the old bankers' motto 'ye who
has the gold writes the rules'. In other words, once the money is formally
advanced there is little room for further negotiation unless problems develop.
Negotiation points that must be answered to the satisfaction of the lender are
the tenor of the loan and the repayment schedule that suits the needs of the
lender and the borrower. Lastly, covenants or restrictions are placed on the
borrower, and the security must be forthcoming to give assurance to the
lender.
• The advice of approval or offer to the client is where the financial institution
formally offers the loan with a set of conditions. Included in this process is
the sponsoring officer (usually the person in direct contact with the
corporate) and senior management (via a statement approval that formally
commits the institution).
• Formal documentation is prepared and exchanged by all parties, and
security is formalised. This process ensures all legal and documentary
requirements are reviewed and met. It is the opportunity for any waivers
or changes to be implemented to the benefit of both the lender and the
borrower.
• Disbursement of funds for the designated activity occurs and the asset is
formally created from a funding viewpoint. These activities can occur only
once valid instructions are received and the necessary documentation is
properly executed.
• The formal process of loan administration and review commences once the
loan is drawn down. The loan is managed and reviewed on a cyclical basis,
with attention given to the correct operation of the loan and the adherence to
the agreement signed prior to draw-down. Major points of review are the
health of the corporate's financials, the state of the covenants and the value of
the collateral. Regular payments assist in the formalised review process
/' -
because they demonstrate commitment and conformity to the original
agreement. Lastly, the behaviour of the borrower is matched to an agreed set
of warning signs or red flags.
• Orderly payment, leading to full repayment, is where the full principal and
interest payments are received on time. This activity sees the loan paid off
without deviation from the loan agreement. Regular repayments occur and
ultimately extinguish the loan. In other words, 'the first way out' payment
cycle is achieved (see page 245).
At this point, the majority of loans are brought to a successful conclusion in
terms of their lifecycle. A proportion of loans will not go according to plan,
however, and the lending cycle accounts for this eventuality by building in the
following actions:
• Prior planning ensures the emergence of unforeseen events within the loan
cycle is identified as quickly as possible. Remedial actions occur to rectify
the situation and get the debt back on track. The fundamental lesson is
that the quicker the action, the less potential there is for a catastrophic
outcome.
• If remedial actions fail, then the loan must be regarded as a loss. Provision is
made under the ruling guidelines of the financial institution, either by
appropriation or allocation.
• The workout situation involves taking action in enough time for there to be a
chance of turning a bad situation into a full repayment. Care must be taken
to make the necessary decisions, because this is the point at which 'good
money can be thrown after bad' in an attempt to redeem the impossible. This
is also the part of the lifecycle where liens over security are enacted. If there
is early recognition of deviations from the agreement, then a formal strategy
can be implemented to measure management actions against a plan for
renegotiating the terms of the loan. At this stage, collection and legal efforts
are rigidly enforced that will either ensure repayment or re-organisation of
the facility.
• Write-off is the final event where the lifecycle is halted. The lender formalises
the loss via an accounting transfer. This transfer can be the principal and/or
the outstanding interest.
Many decisions need to be made during the lending cycle. These will be
faced and made by many different people over the life of a loan. They can vary
from the need for a credit check to an examination of the credit needs of the
client at the origination stage. The funding stage involves decisions based on
the type and cost of funding. Finally, the management phase involves review
and monitoring.
Structuring
theloanproposal
Any loan needs to be structured to account for the cashflows generated by the
opportunity behind the application. A loan needs to be invested in oppor-
tunities by a business to generate sufficient cash to pay back the loan principal
and any interest. In other words, a loan is used to create cash that is greater
I 250 Pari 4: Corporateandbusinesslending

than that needed to expunge the loan. The difference is the profit gained by the
risk taken by the borrowing entity. Loan structuring is about creating the
optimum terms and conditions from both the lender's and the borrower's view-
point, and must account for issues such as loan amount, maturity and repay-
ment. It is vital to realise that the basic methods of assessment are the same for
a large corporate and a small enterprise; lending to the larger corporates, how-
ever, has its own distinct features and pitfalls.
The successful lender ensures answers to certain questions are obtained and
analysed before the actual advance takes place. The following are examples of
these questions:
• Is the loan amount sufficient to accomplish the task?
• Is the cash available and is it identifiable for repayment?
• What is the term of the debt: is it long term (that is, over twelve months) or
short term (under twelve months)?
• If it is long term, do the future projections of cashflow demonstrate
sustainability and does the purpose of the loan match the term (that is, fixed
asset acquisition)?
• If it is short term, does the asset conversion cycle, along with the working
capital efficiency, generate sufficient cash for repayment?
• Does the borrower demonstrate a seasonal need and conform to peaks? Or, is
the corporate a revolving borrower that is bordering on hard-core debt?
Finally, great care needs to be exercised to avoid double dipping of
security - that is, taking the assets of the company as security, along with a
shareholding of a director or owner. In other words, the lender should avoid
taking security over both the assets and the liabilities of the borrowing
entity.
Smallcorporate
entities
Banks and financial institutions automatically divide clients into categories:
personal clients, small businesses, medium-sized enterprises, small corporate
entities and large corporate entities. Different institutions undertake the seg-
mentation process differently, depending on the strategic thrust of the bank or
financial institution. The segmentation methods are similar in that they are
based on turnover, employee base, client book and so on. Small corporate enti-
ties as discussed here are at the medium to upper end of the sector of small
and medium-sized business. They are not limited to listed companies, because
some of the largest entities in a modern economy are privately owned or
strong family businesses. The lender faces Significant pitfalls in this segment of
the loan market because the borrower can vary from a solid organisation to
one that initially appears strong and vibrant but is actually fundamentally
flawed.
A characteristic of this segment is the suspect nature of some of the financial
statements. They are presented to give comfort to the investors and do not
necessarily reflect the true nature of the firm.
Largecorporate
entities
Some financial institutions structure their corporate lending into a separate dis-
crete activity; allowing efficiencies and a concentration of highly trained staff.
The basic methods used in assessing larger companies are the same as for other
segments; there are some discrete differences, however, because this end of the
market does not need the banking system to the same extent that other seg-
ments do, owing to its ability to interact directly with the money markets. In
other words, large companies do not always need the banks or financial insti-
tutions for funding or treasury services.
Large corporate entities can obtain funds directly from the market by issue of
their own paper. They usually have their own treasury function and obtain
advice and services from a range of advisers, some of whom may have resources
in excess of those available to a lending institution. Because their paper is trade-
able, there is intense scrutiny by the investment community. Transparency of
information is a key success factor for long-term survival. Not all public com-
panies or large corporates are well managed, as history tells us, but audited
accounts generally make their financial statements more reliable than those of
other segments in the loan portfolio. In the case of listed companies, the con-
stant scrutiny of their share price and the involvement of rating agencies mili-
tates against bad performance.
Successful lending institutions at the high end of the market in the future
will be those that develop and supply new and innovative lending solutions
together with traditional lending products that allow for diversification across
product and industry segments. Paramount among this new generation of fin-
anciers will be those financial institutions that supply and enhance the financial
risk management functions of the corporate entity.
Product
structure
and.application
Products available to the corporate sector are essentially the same as for the
market in general: term loans, term loans with bill conversion, bill facilities,
overdrafts - in other words, intermediated funding. It is important to read
other books that go into much more detail about the specific characteristics of
loan products, because a loan officer has a particular duty of care to offer the
best available mix of loan products to their clients. This duty of care is both
moral and legal.
Larger corporates have access to a wider variety of products and providers
than normal. Some are large enough to access the market themselves and obtain
funding from the capital market directly; in some cases, their strength may be
equal to or greater than that of a financial institution. Distinctive features of a
modern large corporate are its high degree of bargaining power, access to alter-
native financial resources, and legal and financial advice of a high quality.
Large corporations often diversify their banking sources, which may have
some benefits for the borrower but can lead to problems if renegotiation or
restructuring is required. All of the lending institutions involved may have to
agree to the amendments before they can take affect.
252 Pari 4: Corporateandbusinesslending

Larger corporates have the ability to access the market directly and avoid
intermediation. They can enter the intercompany market, place paper privately,
and approach and interact with institutional investors and funds via dedicated
in-house treasury operations. An important funding source in this segment is
the intercompany loan, whereby one company will lend to another company
that it has agreed to deal with in lieu of a bank loan. This leads to a correct
matching of funding for the firms involved: one company has its deficit covered
and the other can use its surplus funds for a better outcome. An intercompany
load can take the form of a direct loan, which is from a parent company to an
affiliate or subsidiary. Corporates with activities worldwide can make use of
back-to-back loans, which are a form of intermediation using parent company
guarantees as the security option, thus allowing for funding across borders with
minimal risk of intervention.
Lastly, a letter of credit forms a strong line across all segments of the commer-
cial market. This facility allows for an orderly transfer of goods and services
across countries, with back-up guarantees from financial institutions around
the world. A key factor of letter of credit is that the writer of the credit super-
imposes its credit standing for that of the applicant.
Some intermediated products stand out as having a particular focus on the
high corporate end of the market.
• Revolving credit can best be likened to a corporate credit card - that is, a
facility with a limit that can be used and reduced, then used again.
• Standby lines are lines of credit that are made available to a corporate without
necessarily being drawn down. They incur an establishment fee and a
holding fee, but the funds are guaranteed to be available when needed.
• Revolving underwriting facilities are available on demand and reinstated to an
agreed amount as repayment occurs.
• Syndicated facilities are a mixture of loan products, such as project financing,
which are shared out across the market or syndicate. Individual participants
have a choice of being involved as merely a guarantor in a fully funding
position. The risk equals the reward in that the greater the exposure, the
greater is the share of the profits and the greater is the proportion of the loss
if the loan goes bad.
• Project finance is in many ways closely related to conventional corporate
finance. Its origins lie in the large-scale resource developments such as
mining, oil and natural gas. Today, project finance has undergone a major
transition, with projects now including a diverse range of activities from
leisure developments to shopping centres, to the facilitation of government's
privatisation plans. Project finance can be difficult to define. Nevitt (1979)
describes it as:
... a financing of a particular economic unit in which a lender is satisfied to look
initially to cash flows and earnings of that economic unit as the source of funds
from which the loan will be repaid and to the assets of the economic unit as
collateral for the loan.
Bruce, McKern, Pollard and Skully 0997, p. 319) describe the following
seven specific features of project finance, some of which build on the definition
provided by Nevitt:
1. The project is a distinct financial entity
2. The project is highly geared, often 75 per cent funded by borrowings with
the balance from equity participants or sponsors.
3. Loans are directly linked to the project's assets and cashflows.
4. Sponsors' guarantees provided to the financiers generally are of limited
amount and do not apply past the project completion date.
5. End users and suppliers often supply credit support.
6. The lender's recourse is limited to the project assets.
7. Finance is generally of longer term than conventional corporate facilities.
An important feature of project financing is the amount or recourse granted
to a lender. The following categories are those that are most commonly used:
0) nonrecourse financing, where lenders have no recourse to any sources of
repayments other than cashflows of the project (an uncommon form of
financing, but sometimes used); and (2) limited recourse financing, where
lenders are restricted in their access to the sponsor for loan repayment before
project completion. On completion, lenders only have recourse to project
cash flows and assets. The project completion date and its determination are
very important to the security on which the lender can call.
The sponsor gains, given the limitations on the lender's recourse and the
flexibility of ownership. The lender gains from the opportunity to charge
higher fees for advisory work or establishment fees. Further, the lender can
monitor cashflows and guarantee that they will not be diverted. Syndication
or sharing of a project financing deal can lessen the risk but still allow
participation.
Creditratingagencies
A rating is the formal opinion of a credit rating agency of the creditworthiness
of an entity, which could be a government, government agency, financial insti-
tution or large company. Ratings provide a basis for comparing the credit risk of
one organisation with that of others (see Coyle 2000).
Credit agencies exist to provide information to investors and other inter-
ested parties. Large corporates, by their nature, will have a credit rating, which
enables them to reach funding sources denied to others without a rating. The
rating system also allows for different entities to be compared along a common
analysis framework, and the analysis is standardised. Financial institutions use
credit rating agency services but do not rely on the supplied information
solely; rather, they use the information as an adjunct to their own analysis.
Credit information also allows for some transparency in the loan pricing
decision.

Credit rating agencies have an impact on the reputation of firms under
assessment. Reputation is regarded as the greatest risk faced by a modern cor-
poration, so a positive credit assessment is seen as a protective measure.
All credit rating agencies use a scale to represent their view of the entity
under assessment. The scales are similar in the sense of outcome, but different
in presentation and layout. It is important to know which agency undertook a
particular assessment and what key or legend that agency uses.
Skillsrequiredoftheloanofficer
Banking changed over the past decade. Previously, lending bankers served an
apprenticeship: that is, they joined a bank at a young age, worked their way up
the ranks and, perhaps after eight to ten years or even more, were trusted with
the institution's money. Now, a tertiary qualification is essential to become a
lender. In the early stages of a lender's development, two problems can therefore
emerge. The individual needs to consciously address these problems. First, the
lack of background or experience can lead to an overreliance on tools and tech-
nology. Second, a degree of professional arrogance can overtake the individual's
commonsense. Holding a degree can give a false sense of security or, worse, an
expectation of performance beyond experience. If the individual is aware of this
potential pitfall, then he/she is on the way to becoming a successful lender. New
loan officers lack experience and may rely too much on theory; it is essential in
the early years that they find a mentor and learn from experience.
An examination of various banks worldwide demonstrates that banking and
lending are truly global in their application. Skills emerge that can be readily
transferred from institution to institution and from country to country,
addressing the overriding issue of culture.
The skills set reads like a job description: a successful lender needs to have
an ability to understand the complexity of the portfolio, to be subjective and
objective in their ability for risk analysis, to be wise in credit administration and
recordkeeping, and to exhibit strong attention to detail at all times. Monitoring
and follow-up of the credit quality of the loan portfolio require a demonstration
of strong credit judgemental skills, which would be enhanced by an ability to
use technology and tools. Lastly, the individual needs clear thinking and early
problem recognition to enable solutions to be implemented at an early stage.
The demands on the loan officer will increase over time as the industry relies
more on technology and less on human judgement. This reliance on technology
will lead to fewer people being employed but with more demand placed on
them. A strong understanding of the application of statistical credit scoring
techniques will become essential as analysis and interpretation of data become
paramount skills. Over time, human intervention will be the exemption and not
the norm, as the statistical approach gains more rigour. Accordingly, the loan
officer of the future will be involved at the faltering end of the loan process,
when he/she will be needed to resuscitate life into a faltering loan.
Theimportance
offinancialstatements
As we noted earlier, even in today's world with all its technology and electronic
solutions, lending is more an art than a science. This is not a contradiction of
the above statement about the future of the lending officer, but rather a com-
ment on where we are today. Judgement is paramount at the corporate end of
the market at the moment, but change is inevitable as the applications of tech-
nology grow. Successful corporate lending requires judgement supported by
technological tools; this is the opposite of what is required for personal lending.
Judgement does not mean 'gut feel', but rather the sifting of information by an
educated professional who has the ability to verify critical issues with objective
sources to provide a high degree of comfort for the lending institution.
Repayment of loans is a future event; the advance of a loan is allowing the
borrower to bring forward consumption to today and pay for that consumption
over a future period. The onus is on the lender to ensure the viability of those
projected future cashflows. To a large degree, the lender does so by analysing
past financial statements and projections of future performance. The verifi-
cation of the future performance relies on the skill of the loan officer, who
always bears in mind the past. Why? If the future statements far exceed what
has occurred, why? What has changed? The aim of credit analysis is to assess
and verify the capacity to repay and the sustainability of future cashflows; to do
so, the loan officer must know with certainty what he/she is looking for in the
financial statements.
Behind all the ratios and numbers, simple questions need to be answered and
facts need to be verified. First, does the value of cash inflows meet necessary
cash outflows? If not, then the business is technically in a position of cash
insolvency, having insufficient cash to meet its operational needs. Second, does
the value of cash inflows to meet the necessary outflows occur on schedule? If
not, then the business suffers from cash inadequacy, or inability to pay on time.
These are important distinctions, because cash insolvency would normally
lead to a loss or write-off for a lender, while cash inadequacy may mean slow or
delayed payment. Failure to identify the problem as one or the other could lead
to poor decision-making that either places a company in reasonable shape into
receivership or supports a company that is in decline. A successful financial
institution has a credit culture that allows lending to occur without losing
much. This is the fundamental conundrum of lending. Trained and dedicated
lending officers act as a buffer to loss by applying careful credit analysis and
sound credit judgement.
Most of the risk in corporate lending revolves around the loan not being
repaid on time, as a result of cash inadequacy. This risk is directly related to
human and economic activity. Risk can be identified and quantified, however,
via the financial variables demonstrated in the financial statements. A detailed
discussion of financial statements analysis appears in chapter 3, but it is impor-
tant to review some issues here.

Working capital is about cash generation, which can be defined as profit plus
noncash items. The risk here is the inability of cash generation to maintain the
basic functions of the business.
Financial analysis is not number crunching to produce a spreadsheet that is
full of ratios and percentages; rather, it is a central focus on risk analysis. Eval-
uation of past successes and failures of the entity allow analysis of the financial
consequences of outcomes and decisions.
Expert financial analysis is an acquired skill; good lenders are educated
and trained, not born. Loan officers must build their technical skills in
accounting, economics, finance and risk management, not to mention their
human skills in management and physiology. When a loan officer can seam-
lessly apply the above disciplines, he/she is ready to apply judgemental
credit analysis.
Managing
theloanportfolio
Financial institutions are in the business of taking risks. Risk is the key to profit
but financial institutions are not in the business of reckless business writing, so
all lending officers must be concerned with loan quality. All lenders, to be suc-
cessful, must understand the subtle difference described in the previous sen-
tence. Lending rates can be raised to build in the probability of loss for a given
loan, but an individual loan cannot be priced for a write-off. Imagine a typical
loan with, say, a 4 per cent net margin per year; it would take twenty-five years
to cover the loss of 100 per cent of the principal, not even accounting for out-
standing interest and overheads. Another way to look at this scenario is that a
financial institution would need to lend twenty-five times the value of a
write-off just to be zero in earnings. This graphically demonstrates that finan-
cial institutions cannot afford to lose much on average on individual loans in
the overall loan portfolio.
Whatcangowrong?
The lending function is among the most important activities, if not the most
important activity, of a financial institution. It provides income and cashflow
run-off that can be allocated to new asset creation and ultimately allocated as
year-end profit. Poor lending can lead to doubtful or bad debts and, therefore,
adversely affect the results.
Some write-offs are unavoidable because the reason for the loss arose after
the advance. A large proportion are avoidable, however, if care in the analysis
and approval process is increased and if awareness of the real causes of loss is
generated. A large body of evidence suggests that up to 30 per cent of all
loan write-offs are bad at the time of approval; the lender just failed to notice
or failed to correctly analyse the entity. It is important to understand that
only a small proportion of loan failures result from fraudulent actions; there
is more danger from errors in the loan approval process than from a loss due
to fraud.
Advances fail as a result of two broad pressures on industry: external pres-
sures, which are largely beyond the control of the individual firm, and internal
pressures, which are largely within the control of the business entity. We will
examine these in turn in the following sections.
Externalfactors
Government regulation and the actions of government may have an impact on
the survival of a business in different ways at different stages of the business
lifecycle. Examples are the Commonwealth Government's introduction of the
goods and services tax (GST) and re- interpretation of principles of fringe ben-
efits tax. These changes can have a dramatic impact on an entity and its ability
to repay the loan, owing to strains on the cashflow.
Technological advances are another external influence. Technology is
advancing at an exponential rate, with an accompanying cost. The cost of tech-
nology may push a firm into liqUidation. A balance needs to be struck between
the benefits of technology (or lack of) within a firm and the costs. An example
is the Australian business community, which is a leading adopter of technology.
Our economy has restructured to accommodate this feature. By comparison, the
emerging Chinese economy is also an adopter of new technology, but not at the
expense of jobs. This example demonstrates that different routes can achieve
the same end. A successful lender will identify the differences. Individual com-
panies can find themselves selling obsolete products because they are unable to
fund research and development.
Rationalisation and globalisation are increasing competition and forcing
change. The rate and type of change are largely outside the control of the single
entity as opposed to the industry segment in general. Examples are the mining
and motor manufacturing industries. Secure companies can find themselves
overnight targets for takeover, which can waste management time as it fends off
unwanted suitors.
Changing consumer preference is also an external pressure. The modern con-
sumer is more fickle than clients of the past and more likely to change service
providers if unhappy. Is the borrower producing a product that the market no
longer wants? A good loan manager will identify this catastrophic event before
the client. From an institutional viewpoint, loyalty is not a common word in the
financial community of today. Institutions striving for market share have cre-
ated a competitive environment that is detrimental to the maintenance of a
long-term client base. Lenders must strive to ensure the customer is serviced
within the lending guidelines, while fostering an ongoing relationship with
re-purchase intent.
Legislation may be passed or re-interpreted with the effect of plaCing the
business in danger of losing its market or function. If so, the company's cash-
flows may become problematic.
Competition is the common thread of the globalised and deregulated
environment we face today. Is the business in a competitive environment or a
potentially monopolistic one where it could run foul of the authorities?

Examples here are Foxtel and Optus, which wish to share cable television in
Australia but have had their application at this stage rejected by the authorities.
The national economic environment is vital to business success. Is the
economy growing or declining - in other words, is the economy in or entering
a boom or recession? What is the interest rate and exchange rate environment?
What is the prognosis for the future economic cycle?
Successful loan officers will have detailed knowledge of the external environ-
ment facing their clients and, in some cases, may be able to identify and suggest
defensive strategies.
Internalfactors
The industrial environment is important. How does the business deal with its
staff and other stakeholders? Is it confrontational or is it seeking cooperation?
Compliance could lead to agreements that have an adverse impact on the via-
bility of the firm.
Lenders also need to examine management style and functionality. They
should focus on the management style (autocratic through to inclusive), the
structure of the administrative system and management's knowledge of their
business. Other issues are the company's recognition of the market and its
financial position, and its use of available resources.
Lenders should look for:
• poor planning and objective setting; demonstrated inability to cope with
change; a lack of a formal planning process; erratic behaviour
• poor organisation and control, whereby the management cannot answer
basic queries, problems occur regularly and recurrently, panic is the norm,
and the company has a history of not meeting agreed deadlines and asking
for extensions
• poor profit planning and control; excessive withdrawals; use of problematic
projects to justify expenditure
• poor resource and personnel management systems; a reputation in the
marketplace as a poor employer of choice; overstocking; inadequate
premises; emphasis on nonproductive assets as a priority
All the above factors can generate adverse outcomes for a loan, so lenders
must be attuned to the nuances of the internal environment of the companies in
their loan portfolios.
Benbow (I985) stated over fifteen years ago: 'At a time when public confi-
dence and trust in commercial banks has been shaken, banks must demonstrate
their financial stability by making sound, liquid loans - a task for loan offi-
cers'. These words could have been written today. They send a warning that the
financial industry is generational and the lessons of one generation are not
necessarily passed to the next. Accordingly, the same mistakes are repeated at
regular cycles; the industry generally seems incapable of learning from the past.
In addition to the external and internal factors, Benbow (1985) identified
warning signals divided into the following five broad categories on page 260.
These signals are still pertinent and active today.
• Borrower's history. When a lender investigates the potential borrower, it needs
to look for any record of previous bankruptcy and any discrepancies in
information received.
• Management concerns. The lender must take care when its client is obtaining
advice from professionals who rely on their relationship with the borrower
for income. Is the relationship based on income or good corporate
citizenship? When speaking to the client, does the lender detect a lack of
forthrightness or fighting within the management team or among partners or
family members? Does the borrower have a demonstrated poor character? Is
there evidence of excessive withdrawals by prinCipals? Lastly, is the borrower
in haste for the loan to be approved and, under that pressure, does the lender
relax the character checking on the borrower? If so, there is the potential for
a bad debt to be created.
• Credit facts. The borrower's credit history is an important indicator of the
future of the loan. Borrowers with bottlenecks or excessive dependencies on
types of support that may have an adverse effect on the business if
interrupted must be treated with caution unless strategies are developed to
overcome potential adverse events. This dependency can be industry wide or
restricted to a single entity. Lastly, loans approved for organisations or
individuals on behalf of organisations whose assets and liabilities are not
clearly defined or easy to locate will sooner or later enter the bad debt basket.
It is essential to identify who owns the assets that are being used for security,
especially in companies structured as trusts.
• The loan structure. Is there a lack of purpose or reason for loan funding? Is
the repayment program more generous than projected cashflows? If so, then
there could be an emerging problem with the loan structure. If the analysis of
the cashflows is problematic, then the second source of payment (or second
way out - see page 245) becomes the only realistic source of repayment. Is
the transaction beyond the capacity of the entity to payor is it based on
finishing a project to generate cash for repayment? Is the owner known as a
deal-maker or entrepreneur? Does he/she have a reputation of acting as a
broker? If so, chances are that he/she will supply inadequate financial reports
because he/she is too busy to spend time on report preparation.
• Changes in established patterns. As the relationship between borrower and
lender develops, care must be taken to identify any changes because it may
be possible to reverse a bad outcome early in the event. A good lender knows
the patterns of activity of his/her clients and is sensitive to any changes
surrounding individual behaviour, espeCially any change in the checking and
verification of account balances. Lenders need to view with urgency any
regular changes in accounting methods and auditors that lead to requests for
renegotiations of loan covenants and conditions or resetting of loan
repayments. When the loan is reviewed periodically, care must be taken to
identify and act on any adverse changes in financial position and reports.
Early action may avert a disaster.
260 Pari 4: Corporateandbusinesslending

As a final comment on bad and doubtful loans, a successful loan officer will
know, alongside the five Cs of credit assessment, the following five Cs of bad
credit extension:
• Complacency is the sin of overestimating the potential of the borrower as a
result of past history. Overreliance on history is lazy lending.
• Carelessness is about a lack of attention to detail, not worrying about the
documentation because it is assumed to be all right. In just about every case
of bad debt or write-off, the loan documentation is suspect or deficient.
• Poor or absent communication contributes dramatically to the breakdown of
business relationships and only worsens the eventual bad debt actions that
need to occur to rectify the situation.
• Failure to set contingencies can mean a lack of focus on the management of
the loan. Emphasis is sometimes given to the successful sale and not the
ongoing management, with the lender failing to establish 'ways out'.
• Competition creates its own pressures. The finance industry is governed by
the herd mentality and sometimes the successful player has to have the
business acumen to stand apart from the pack.
Advicefromthepast
Many generations of bank manager have learned that it is to their detriment to
ignore the wise words of those that have gone before them. Some key consider-
ations are discussed below, representing the collective corporate memory of
many credit managers:
1. Never work alone because then you have only one opinion. A team
environment in the lending process is an essential component for success.
It is one reason that the lending approval process has been separated from
the selling or origination phase.
2. Procrastination leads to looming deadlines and decision by panic.
Ensure there is enough time for a reasoned decision to be made; the
transaction that is hurried is the one that will go bad. Remember,
one-third of indicators for bad and doubtful debts are present before a
dollar is lent.
3. If you want to be a good guy and accept customer information at face
value, then you will have a short but spectacular career in lending. You
must ensure all facts and figures are checked and verified before approving
an application. A client will never be more cooperative than before the loan
is approved.
4. Even in the marketing environment of today, a professional lender will not
jump on command in the deciSion-making process. The selling of the loan,
where time and active response are paramount, must be separated from the
loan approval process, where attention to detail is essential to protect the
funds of the lending institution. This aspect must not be confused with
procrastination. Worse, do not be stampeded into a decision by an unreal-
istic time frame.
5. Never be submissive and forced into making bad decisions; it is a fine line
between being firm about obtaining the information needed for a decision
and fawning to a client for business expansion and retention. Patience is a
virtue, but excessive patience can lead to disasters in lending.
6. Never promise what you cannot deliver because you will destroy your
credibility and reputation. Once those facets have been compromised, you
and your institution have no future in the long term.
7. When analysing the loan application, factor both qualitative and quanti-
tative information into your decision. If you stick solely to the figures
when making loan decisions, you will break the fundamental rules of
lending: that is, lending when you should not and not lending when you
should.
8. If you place your faith in a volume relationship rather than a quality one,
you will have lots of work and activity but little profit. Identify the clients
who add most value to your portfolio. Once you have identified these
accounts, profitability can grow even in a climate of declining loan vol-
umes. Balance this aspect with the culture and requirements of the insti-
tution to which you are ultimately accountable.
9. The purpose of the loan is the key decision factor of the loan approval pro-
cess; failure to identify the purpose and lending money solely on ability to
repay sets the scene for a future bad debt. The purpose of the loan should
also indicate the repayment ability of the loan. A lack of emphasis on the
real purpose behind loan proposals was a major factor in the bad debts
created in Australia in the past decade.
10. If you settle for the information you have and stay at your desk, you will
miss opportunities for business creation. Worse, you will make decisions
in a vacuum. It is essential to visit your clients and see how businesses
operate at their origin.
II. If you only record facts on the history file during the down time you will
miss essential information that may be needed in the future. Documenta-
tion can be called as evidence for any court case, so it is essential to record
all relevant facts at the time of occurrence. An examination of claim settle-
ments before formal court action will demonstrate that lack of information
was a key factor in lenders settling before the hearing.
12. Confine your relationship with clients to loan and credit problems; do not
become a friend or confidant, or you may confront a conflict of interest in
the future. Many good bankers have shortened their careers by over-
stepping the bounds of the banker-client relationship.
13. Ensure the relationship with a client allows for all information to be gath-
ered in a timely manner. Not to worry your client with minor details - for
example, insurance coverage or policy renewal - is to let down the client
and your institution.
14. Putting your faith in the future and developing a narrow focus on docu-
mentation leads to a lazy mindset and creates a loan officer who is reactive.

15. Always remember that a loan must have at least two ways out: approving
loans based solely on cash flow will lead to a higher proportion of bad debts
than ones approved with the full backing of security. When a loan is
approved, the use of the funds should determine the repayment source.
Also remember that the client needs to generate positive cashflow to grow,
so the repayments should not tie up your borrower's cash capacity too
tightly.
An examination of the above factors teaches us that loan officers cannot rely
on the past or friendships, or overrely on documentation to stave off bad debts.
The only protection is constant care and forethought, looking at what 'could
be'.
We have looked at the purpose of corporate lending and how it forms the
backbone of a successful large-scale financial institution. The loan portfolio and
its construction is crucial to survival of the financial institution.
As with all activities in finance, there are overriding principles. Ignorance of
these principles and failure to implement the basics can lead to disaster. These
principles, correct lending assessment and the ability to read and understand
financial statements become the tools of trade for a loan officer.
An understanding of the lending cycle is important for comprehending the
differences between a financial institution and other corporates, and for the
skills of the loan officer becoming param'ount in hislher development. This
understanding ensures a loan proposal is structured for an optimal outcome,
both for businesses in obtaining funds and for lenders in ensuring safe loans.
Summary
1. What are the principles of corporate lending?
The main principles are safety, SUitability and profitability. In addition, the
lender should establish ways out of a loan.
2. Why is the application of lending criteria critical to success for a modern
financial institution?
Adherence to a lending policy and substantiated lending criteria allows the
growth of a loan portfolio in line with the desires and capability of the
lending institution. Set criteria allow for audit and risk management to occur
on a timely basis.
3. What are the contents of the loan proposal document?
A good loan proposal document allows for quantitative and qualitative
matters to be balanced so formal analysis can occur. It allows for analysis of
cashflows and demonstrates the ability of the borrower to service the loan.
4. Why is financial information so important?
Detailed analysis of a company's financial documents allows cash inflows to
be identified and matched with outflows, to demonstrate viability and sol-
vency. In addition, it allows for the value and contribution of working capital
to be identified.
5. Why is it necessary to manage the loan portfolio effectively?
The loan portfolio represents the major asset base of a modern corporate
lender. Effective management allows value to be harvested and assures inves-
tors of the strength of the institution.
6. What are some of the key loan products?
At the top end of the market, corporates use all lending products that are
available to other business segments. In addition, their credit rating allows
access to revolving credit lines, syndicated facilities and major project
financing products.
asset mix, p. 243 five Cs, p. 245 PARSER, p. 245

back-to-back loans, p. 253 hurt money, p. 244 principles of lending,
cashflow, p. 243 intercompany loan, p. 253 p. 242
credit rating agency, lending criteria, p. 242 segment, p. 242
p. 254 lifecycle, p. 242 working capital, p. 257
direct loan, p. 253 loan portfolio, p. 242
uestions
1. What are the three main principles applied to corporate lending pro-
posals?
2. The five Cs is one method of structuring a loan approval process. What
fundamental piece of information does it ignore or fail to highlight?
3. What are the three components of a corporate loan?
4. Do you think that an understanding of the three components noted in
question 3 would allow for a correct segmentation of loan duties and
functions within a financial institution?
5. In recommending approval of a loan, how does a loan officer reconcile
the needs of the borrower with the bank's objective of making a profit?
6. Discuss the veracity and value of the lending cycle.
7. An evaluation of the worth of the three ways out of a loan may lead to a
modification of the loan approval process. What changes may occur?
What additional information may be needed?
S. Attempt to overlay the five Cs and PARSER on the formalised lending
cycle shown in figure S.I.
9. Refer to the lending products listed in this chapter to meet the needs of
corporates. Are any of them practical to offer as a replacement for a
large corporate's interaction in the direct market?

10. Should a loan officer be involved in the cross-selling of various insti-
tutional products or should this be the function of other parties
employed by the financial institution? In your discussion, define and
develop what is meant by a 'full relationship with the client'.
References
andfurtherreading
Benbow, R. F. 1985, Preventing Problem Loans before They Happen, R. F. Benbow
and Associates, Sydney.
Bruce, R., McKern, B., Pollard, I. & Skully, M. 1997, Handbook of Australian Corporate
Finance, 5th edn, Butterworths, Sydney.
Coyle, B. 2000, Credit Risk Management: Measuring Credit Risk, CIB Publishing,
BPP Financial Education, London.
Mather, L. C. 1972 The Lending Banker, 4th edn, Waterlow, London.
Nevitt, P. K. 1979, Project Financing, Euro Money Publications, London.
all busine lend g
Introduction
Small business lending is a specialised area of lending that is undergoing major
changes both around the world and in Australia. In the first part of this chapter,
we will provide an overview of small business lending in terms of the form it
takes, how financial institutions organise their lending operations, the degree of
competition in the market, attitudes of borrowers and, lastly, a comment on the
political dimension to small business lending. We will examine many of the
changes that are occurring in Australia.
In the second part of the chapter, we will develop a theoretical base for small
husiness lending. We will use this theoretical base to explain some of the
changes that are occurring in Australia and the United States.
We will then narrow the perspective to the level of the individual small
business lending decision. We will identify distinctive characteristics of small
business that cause small business lending to be so risky. We will compare the
two different approaches being used to make small business lending decisions:
a relationship management approach versus a credit scoring approach.
Finally, we will attempt to predict how small business lending may change
over the next five years.
Anoverviewofsmallbusiness
lending
Here, we will discuss the nature of small business and small business lending.
Whatis smallbusiness?
The term 'small business' is defined in a number of different ways in Australia.
The Australian Bureau of Statistics defines a small business as a business having
fewer than twenty employees. This one-dimensional measure provides an objec-
tive and relatively simple criterion for classifying the large numbers of busi-
nesses about which the bureau collects information.
According to the Reserve Bank of Australia (2001, p. 29), a small business:
• 'is independently owned and operated; and
• is closely controlled by owners/managers who also contribute most, if not all,
of the operating capital'.
The bank also considers that a small business is one with loans less than
5500 000 (Reserve Bank of Australia 1997a, p.l). Like the Australian Bureau
of Statistics, the bank has created a definition that it can readily apply to the
statistical information that it collects from other banks. The bank earlier
argued that loan size was a reasonable proxy for business size as measured
hy numher of employees or turnover (Reserve Bank of Australia 1994).
Information available to the bank led it to conclude that a business with a
horrowing of 5500 000 would, on average, have a turnover of $5 million.
The bank considered that this was a realistic cut-off point for defining small
business.
/ -
Smallbusiness
intheeconomy
Using the Australian Bureau of Statistics definition, there were 1 175000 small
businesses operating in Australia in 1998-99. Collectively, these small businesses
represent 95 per cent of the total number of businesses and produce 30 per cent
of all private sector output. Data quoted later in this chapter indicate that over
half of all small businesses consist of only one owner (and no employees). By
way of contrast, the average small business has three employees. In aggregate
terms, employment by small business represents 40 per cent of the total work-
force and 50 per cent of the private sector workforce.
TABLE 9.1 Small business in the economy, 1999-2000
Employment Shareof industry

Numberof small ------ ----- Shareof industry operatingprofit
businesses(a) Number Shareof industry sales(b) beforetax(b)
('000) ('000) (%) (%) (%)
Agriculture (c) 100 249 74 na na

Mining (c) 2 9 12 12 36
Manufacturing 86 275 29 13 28
Construction 209 474 82 55 68
Wholesale trade 64 244 43 31 24
Retail trade 165 590 48 43 69
Accommodation, cafes and
restaurants 31 183 44 40 44
Transport and storage 64 163 52 21 19
Finance and insurance 24 58 20 30 40
Property and business
services 207 584 55 47 57
Education 25 65 31 na na
Community services 69 230 43 46 71
Culture and recreation 38 91 47 15 18
Personal and other services 77 184 71 52 43
Total private sector (d) 1175 3430 49 30 39
(a) Excludes public sector.

(b) Data are for 1997-98 and exclude agriculture and nonemploying businesses.
(c) Number of businesses and employment data are for 1998-99.
(d) Includes utilities and communications.
na Not available.
Source: Australian Bureau of Statistics, cited in Reserve Bank of Australia 2001, Reserve Bank of Australia Bulletin,
May, p.29.
As indicated in table 9.1, small businesses operate over a variety of different

sectors of the economy. The Reserve Bank of Australia (2001) notes that small
business is most commonly found in the property and business services, con-
struction and retail sectors. Half of small business employment is found in these
sectors. The sales and output of small business are only 30 per cent of total
sales and output, even though small businesses account for 50 per cent of total
employment in the private sector. This reflects the labour-intensive nature of
many small businesses, particularly those in the construction and retail sectors.
I 268 Part 4: Corporateandbusinesslending

The Reserve Bank of Australia (2001) also provides the following interesting
statistics:
• Working hours for persons in the small business sector tend to be higher
than for those in the rest of the economy. In 1998-99, 20 per cent of the total
workforce worked at least 51 hours per week, whereas the percentage for
small business was 25 per cent.
• In 1995-96, just under 8 per cent of small businesses stopped trading,
compared with 5 per cent of medium and large businesses.
• In 1998-99, almost 43 per cent of small businesses with employees were
structured as a company, compared with 70 per cent of larger businesses.
Sale proprietorships, and partnerships and trusts accounted for 17 per cent
and 38 per cent respectively of the legal structures used by small business.
Somecharacteristics
ofsmallbusiness
lending
Data on small business lending are provided mainly by the Reserve Bank of
Australia, which began collecting data in 1993 around the same time it estab-
lished its Small Business Finance Advisory Panel. Table 9.2 (page 271) summar-
ises some of the main features of small (and larger) business lending.
• In dollar terms, small business lending is one-third of the size of lending to
larger businesses.
• Small business pays 1.6 per cent more for its borrowings than larger business
pays for borrowings. This difference reflects two main influences. The first is
the higher default risk associated with lending to small business (as discussed
in detail beginning on page 288). The second influence is the economies of
scale (that is, on a percentage basis, the opportunity with a large loan to
spread more thinly the fixed costs of approval and ongoing management).
Finance to small business takes three main forms:
• floating rate finance
• fixed rate finance
• bill finance.
Figure 9.1 (page 270) provides an overview of how the percentage share of each
of these three forms of small business finance changed over the period 1993-2001.
Floatingrateloans
The interest rate charged on floating rate loans can change over time. For small
business, the main type of floating rate loan is the overdraft, with half of small
business finance typically in this form (Reserve Bank of Australia 1994, p. 30).
The advantage of the overdraft for small business is that it is very flexible. The
funding needs of a small business can be difficult to predict, but an overdraft
provides a flexible source of finance which can be accessed as required up to the
pre-set limit. The flexibility of the overdraft comes at a cost, however. Table 9.2
(page 271) indicates that overdraft finance is typically 1.5 per cent more expen-
sive than bill finance, which is the main alternative form of short-term finance.
The other form of floating rate finance is the fully drawn advance, which is
different from an overdraft mainly in that the full amount is drawn at the outset
Fixed rate
50
40
Floating rate
......
-;;R.
30
So
-
'0
l!!
III
m20
Bills
10
1995 1997 1999 2001

FIGURE 9.1 Composition of small business loans
Source: Reserve Bank of Australia 2002, ,Reserve Bank of Australia Bulletin, February, p.59.
of the loan. Repayments are typically made in regular instalments. The floating
rate nature of the fully drawn advance means that the interest rate charged is set
at a margin over an indicator lending rate. The margin reflects the credit risk
involved and the indicator rate is often known as a prime lending rate. The
prime lending rate tends to move up and down in line with bill rates, which, in
turn, move with the Reserve Bank's cash rate. (Remember, this cash rate is the
means by which monetary policy is implemented in Australia.)
Fixedrateloans
The interest rate on these loans is fixed for the life of the loan. Fixed rate
finance, at 42 per cent of total small business finance, is also a significant form
of finance. It is typically taken over three to five years and can be used to
finance the purchase of noncurrent assets such as property, plant and equip-
ment. The three-to-five-year fixed rates tend to be determined by three-to-five
year Treasury bond rates with a margin added for credit risk. The weighted
average interest rate of 8.5 per cent for all existing fixed rate finance is relatively
stable over time because the cost of an individual loan is fixed for the typical
life of the loan. Another factor influencing the cost of fixed rate loans in

relation to variable rate loans is the prevailing shape of the yield curve: if the
yield curve is strongly positive, then floating rates will be significantly less than
fixed rates.
Billfinance
Bills are a discount security which are typically issued for periods of around
ninety days. Bill lines at 8 per cent are a minor form of finance for small busi-
ness; in contrast, larger businesses have bill lines as their dominant form of
finance. The Reserve Bank of Australia (1994) suggested that small businesses
prefer the flexibility of overdrafts in managing an uncertain cashflow. Bill lines
are less flexible because they are typically drawn for a period of ninety days.
If the bills have a face value of $500 000 and are discounted at a price of
$490 000, then the company is effectively paying interest on the full $490 000
borrowing during that ninety-day period, irrespective of whether it needs that
full amount for the whole ninety days. Also, if the company needs to borrow
a little more than $490 000 at some stage during the ninety days, then it
cannot do so via bills. Offsetting the inflexibility of bills is their significantly
lower cost.
TABLE 9.2 Bank lending to business - total credit outstanding and weighted average interest rate,
by size and type of facility, June 2001
Smallbusiness
lending Medium-to-Iarge
business lending
(under$500DOD) ($500DODandover)
- - - - - - - - - - - - - - - - - - - - - - - - - - Total
Variable Fixed Variable Fixed business
rate rate Bills Total rate rate Bills Total lending
$ million 33037 28042 5228 66307 43377 41244 113749 198370 264677
Share (%) 50 42 8 100 22 21 57 100
Share (%) 25 75 100
Weighted average
interest rate 8.3 8.5 6.8 8.2 7.2 7.1 6.2 6.6 7.0
Source: Reserve Bank of Australia 2001, Reserve Bank of Australia Bulletin, November, pp.834-835.
Table 9.2 concentrates on bank lending to small business, so it may be worth-

while to pose some questions. To what extent do we have only part of the small
business finance picture by concentrating on lending by banks? Or, put another
way, how Significant is nonbank lending to small business? Table 9.3 (page 272)
provides some answers to these questions. In terms of all loans and advances,
banks outnumber nonbanks by a factor of four. Financing via bank bills shows
a two-to-one ratio in favour of banks. When these two elements are added
together and overall credit is considered, the business component at $339 bil-
lion represents 48 per cent. Referring back to data in table 9.2, we see that bank
lending to business equals $265 billion. The conclusion we can draw from
these two figures is that banks account for 78 per cent of lending to business.
Ideally, the next step would be to calculate a similar percentage for bank
lending to small business. Unfortunately, the data required for this calculation
are not available.
TABLE 9.3 Selected lending and credit aggregates, June 2001
Share (%) 80 2.0 100 27 13 60
Share of 89 3 1 7 100 100 42. 10

all credit
(%)
Note: Data are not seasonally adjusted.
Source: Reserve Bank of Australia 2001, Reserve Bank of Australia Bulletin, November, pp. S25-S26. Table D.2
A conclusion is that banks are the dominant business lenders in Australia. A

reasonable inference (in the absence of more detailed data) is that banks are
also the dominant small business lenders. This was the view of the Reserve
Bank of Australia (l997a, p.l) when it stated that 'small business operators
look to the banking sector to provide most of their needs for debt finance'. Data
provided later in this chapter support this view. The data (survey results pub-
lished by the Yellow Pages® Small Business Index) indicate that 79 per cent of
small businesses use a major bank as their main financial institution; 15 per
cent mainly use smaller banks; and 6 per cent mainly use nonbank financial
institu tions.
Howlendersorganise
theirsmallbusiness
lending
Major changes are occurring in the way in which business lending is organ-
ised in Australia, paralleling changes occurring overseas. Traditionally, a
business account was located at a bank branch, with the manager being the
point of contact for the business customer. This concept of a branch manager
as a business lender has now largely disappeared. The relationship manager
now exists in place of the branch manager. The relationship manager's brief
is to maintain and develop relationships with a collection of business bor-
rowers. If, for example, the business borrower is having cashflow problems
or wants to make extra borrowings, then he/she contacts the relationship
manager. More information is provided in the 'A day in the life of ... ' box on
page 282.

Few of us would be in a situation where our individual accounts (retail
accounts) are relationship managed. Relationship management is normally the
case only for high net worth individuals. For the rest of us, we make any
enquiries via a telephone help line. If we want to take out a personal loan, then
we obtain the necessary form, fill in the information required and email/send it
to a central office. Financial institutions are increasingly encouraging us to
undertake these processes via the Internet. Behind the scenes, our loan appli-
cation is probably credit scored and then electronically approved or declined.
Individual accounts are thus run centrally and largely anonymously, and have
been done so for some time.
The recent change in business lending is that financial institutions have
begun organising their smaller business loans along similar lines to their retail
accounts. This means that these smaller business customers:
• have their accounts centralised
• have no relationship manager
• can be subject to automated credit scoring processes if they require a new
borrowing or an increase in an existing borrowing.
What is the typical cut-off point for a 'smaller' business loan? Interesting
changes have recently occurred in this area. The two largest small business
lenders, the National Australia Bank and the Commonwealth Bank of Australia,
have been part of this change.
The National Australia Bank (2001, p.26) recently described itself as the
'largest lender to small and medium businesses in Australia'. For a number of
years, the bank used a cut-off of $100 000 to mark the transition from centrally
managed to relationship managed business accounts. More recently, it increased
the cut-off point to $250 000, although in certain circumstances it will allow
exceptions for businesses with more complex funding needs. Despite the excep-
tions, the bank's intentions are clear: it wants to reduce the proportion of small
business loans that it relationship manages.
The National Australia Bank now uses central management for around 60
per cent of its small business accounts. This proportion is based on the infor-
mation contained in table 9.4 and an assumption that loans between $1 00000
and $500 000 are evenly distributed over that range. This share is a big increase
on the estimated 32 per cent that previously were centrally managed under a
cut-off point of $100 000.
TABLE 9.4 Bank lending to business, 30 June 2001
Smallbusinesslending Medium-Io-Iargebusinesslending
------------------------------------------------
Under $10000010less $50000010less $2million
$100000 than$500000 than$2million andover Total
$ million 21870 44437 40332 158038 264677
Share (%) 8 17 15 60 100
Source: Reserve Bank of Australia 2001, Reserve Bank of Australia Bulletin, October, p.833.
The Commonwealth Bank looks to be going even further than the National
Australia Bank in lifting its cut-off point. It began trialling changes in Western
Australia at the start of 2001. The new arrangements have the following
characteristics:
• All small business accounts (those involving borrowings of less than
$500000) with straightforward funding requirements are moved to a
centrally managed location.
• The exceptions are those accounts where the financial needs of the business
are complex. An example of such a business would be an exporter that
reqUired letter of credit finance and forward exchange rate cover on a regular
basis.
• Credit scoring is not to be used.
This increase in the cut-off point for both banks will probably require a sig-
nificant change in the culture of small business lending to be successful. Histor-
ically, small business lenders have analysed financials, talked to the customer
and the accountant, and visited the premises of the business as part of
approving finance and managing the bank's exposure. With central management
of business accounts, this process will be the exception rather than the rule.
Assuming that other business lenders follow the lead of the above two banks
and increase their cut -off point, what are the likely implications of this change;>
Here, we suggest some possibilities:
• Lenders will be able to reduce the cost of 'vanilla' deals. To illustrate,
consider a small business that has landed security, a strong loan-to-value
ratio, reasonable interest coverage and a track record of successful operation.
In this case the lending decision is very clear. A credit scoring model could
feasibly be used to make decisions on this type of loan.
• For more complex businesses and lending deals, the outlook is not so good.
Take the case of a business that is looking to borrow $200000 but has a weak
security position and has been in operation for a relatively short period. Such
a business will find it either more difficult or more expensive to obtain finance.
• For some borrowers, the loss of a relationship manager (and the move to
centralised management) will not be well received. Statistics quoted later in
the chapter indicate that small business borrowers are becoming increasingly
unhappy with their lenders.
• For the financial institution, the move to the increasingly centralised
management of business accounts will require a number of changes to be
successful.
Business lenders are faced with a trade-off. On the one hand, relationship
banking has benefits. According to the National Australia Bank, the relationship
banking model was a key factor in its growth over 2000-01. This model
allowed the bank to develop a detailed understanding of what the business cus-
tomer wanted (National Australia Bank 2001, p. 26).
On the other hand, however, relationship banking has a high cost. Putting it
another way, it costs more than centralised management, which uses online
approval and management. The National Australia Bank (2001, p.26)
I 274 Pari 4: Corporateandbusinesslending I

acknowledges this point: 'we have also established a new Package Business div-
ision for small businesses with relatively straightforward financial needs, which
enables the delivery of efficient service at low cost'.
In summary, the cut-off point between relationship managed and centrally
managed small business accounts is a question of judgement. This cut-off point
is likely to continue to be increased over time, however, as business lenders
strive to reduce the critical ratio of costs to income. The major banks reduced
this ratio by approximately 30 per cent over the four years to 2000, when they
reached SS.3 per cent. They are rapidly approaching world best practice of SO
per cent. Continued reductions, partly via increased centralisation of small
business lending, is seen as essential by industry analysts (KPMG 2001).
Competition
inthesmallbusiness
lendingmarket
There is evidence of an increasing level of competition in the small business
lending market. The Reserve Bank of Australia (1999) describes the level of
competition as intense. The main area of competition has been with business
loans where residential property is available as security. This competition
started in mid-1996 when one bank offered a slightly discounted borrowing rate
for new borrowers who could provide residential property as security. In 1997,
rates were reduced by about 2 per cent for all business borrowers (new and
existing) that had residential property as security. In addition, customer risk
margins were no longer applied. The next major changes occurred in 1998:
first, further cuts were made in the small business indicator rates and, second,
business loans secured by commercial property or higher quality business assets
were priced at a fixed risk margin. This latter change was significant because it
meant that each customer no longer had an individual risk margin.
Arising from all this change is a small business loan market offering a wide
range of different products as well as a different way of loan pricing. Some
loans, where good-quality security is on offer, are priced at a fixed margin over
some indicator rate. Other loans are priced individually according to the credit
risk of the borrower. The Reserve Bank of Australia's (1999) judgement is that
this competition has resulted in a significant amount of small business funding
being moved to residentially secured loans.
A trend of increasing competition in the small business market fits with
banks' changes in the way in which they organise their business lending:
• Banks are trying very hard to reduce their ratio of costs to income. Credit
assessment and management of small business loans can be expensive, given
the spread of risk factors involved plus the limited ability to spread the fixed
costs of assessment and management over a smaller loan.
• If a small business borrower is able to provide landed security, then this
greatly reduces the need to undertake a detailed credit assessment of the
'first way out'. Such a loan can probably be handled via a relatively simple
credit scoring process. Another advantage of lending to a borrower with
residential security is the concessional SO per cent risk weighting that the
loan attracts for the purpose of calculating capital adequacy. This contrasts
with a 100 per cent risk weighting for other types of business loan. For these
two reasons, banks have been aggressive in trying to attract borrowers that
have landed security.
• At the same time, lenders have been moving to manage a good proportion of
these borrowers through a central location rather than through the more
expensive alternative of relationship management.
These changes may be behind the deterioration in small business borrowers'
attitudes towards their lenders, as we will discuss in the next section.
Smallbusiness
attitudesto lenders
Small business attitudes to lenders are regularly surveyed by both the Reserve
Bank of Australia (through its Small Business Advisory Panel) and the Yellow
Pages® Small Business Index. The Reserve Bank does not formally publish the
results of its panel discussions, but occasionally refers to these discussions (see
Reserve Bank of Australia 1997b).
The Yellow Pages® Small Business Index publishes quarterly special reports,
including reports on small business attitudes to banks and other financial insti-
tutions. A recent report in November 1999 (Yellow Pages® Small Business Index
1999) noted the following main points:
• Seventy-nine per cent of small businesses used a major bank as their
main financial institution in 1999, 15 per cent mainly used smaller banks
and 6 per cent used nonbank financial institutions.
• The National Australia Bank and the Commonwealth Bank of Australia were
clear leaders of the major banks, with each holding 24 per cent of the market
share in 1999.
• About one in three small businesses in 1999 were not happy with the service
of their main financial institution, significantly higher than one in five in 1993.
• The satisfaction rating with individual majors was variable in 1999. The
biggest falls were for the National Australia Bank and ANZ. From August
1995 to August 1999, the National's satisfaction rating dropped from 83 per
cent to 60 per cent, and the ANZ's rating dropped from 82 per cent to 54 per
cent. The Commonwealth's pOSition was effectively unchanged (down from
74 per cent to 73 per cent), while Westpac's improved (up from 71 per cent
to 80 per cent)
• The reasons given by small business in 1999 for not being happy with bank
service were 'poor/no service' (42 per cent) and 'no personalised service' (up
from 18 per cent in 1995 to 27 per cent). For those businesses that dealt with
a small bank or nonbank financial institution, the corresponding figures were
37 per cent and 14 per cent respectively.
• Sixteen per cent of businesses changed their financial institution during the
two years to 1999. A disproportionate number of businesses that moved from
a major bank went to a smaller bank or a nonbank financial institution.
• The main reasons that businesses changed to a smaller bank or nonbank
financial institution were 'better service' (47 per cent) and 'lessllower fees'
(32 per cent). Fees are the topic of the following 'Industry insight'.

businesses bear a dis-
•share of bank lending goes
in late July, found that in

fees on their loans while
outstanding loans of $500 000 and over.

up most of the tab for bank fees on deposits, paying
with $115 million paid by large businesses.
at a time when the Small Business Ministerial Council
Government to seek an Australian Competition and
nnll11""t'intopossible anti-competitive practices by banks
also showed that small paid 1.49 per cent

deposits in 2000, while largebiisinesses paid 0.76 per cent.
pointed out that fees paid by sfuall businesses have grown more
from large businesses in recent years, partly reflecting a decline
in small business loan charges, especially for overdraft loans.
Bankfees on businessloans
800
• Small business • Large business
600
I:
.2
'e 400
ut
200
o
1997 1998 1999 2000
Source; Reserve Bank of Australia Bulletin.
(continued)
For instance, the establishment fee on a standard $100000 loan [fell] from
$925 in 1997 to $740 in 2000.
Despite a slowing in growth, small businesses paid 29 per cent of all bank
fees in 2000, while large businesses paid 31 per cent.
The chief executive of the Council of Small Business Organisations, Mr Rob
Bastian, said banks charged higher fees for a small business loan because small
businesses were regarded as higher risks.
'[Butl given that about 75 per cent of all small business borrowing is secured
against the family home, and there is little risk for the bank, these higher fees
have been a mystery to me', Mr Bastian said.
Banks continued to define their risk separately from the security they took
over a loan. 'Neither small businesses nor the banks benefit from this unhappy
relationship', Mr Bastian said.
Small business fees not unfair, say banks

The Australian Bankers Association has hit back at suggestions that the major
banks are unduly severe on bank fees for small business loans, pointing out that
business loan fees have been declining as a proportion of outstanding balances
for all businesses, large and small, since 1992.
In addition, small business is about to be included in a new draft of the code
of banking practice in a final issues paper that is expected to surface towards
the end of September.
To date, small business hasn't been included', said Mr Stephen Carroll, an
Australian Bankers Association director handling small business, rural and
e-commerce issues.
The code has applied to individuals, not businesses. We are looking at
including small businesses, essentially where they're operating their bank
account in a way similar to consumer banking.'
The long, drawn-out review has been under the supervision of independent
reviewer Mr Dick Viney. Small businesses have had access to the Australian
Banking Industry Ombudsman since 6 July 1998.
The debate over small business banking fee costs stems from the annual
survey of fee income for eighteen Australian banks covering 91 per cent of total
banking sector assets.
As reported in the Australian Financial Review last week [Tuesday,
7 August 2001], a table on bank fees from businesses showed that while
small business paid $643 million in loan fees in 2000, the big business
total was lower at $542 million, even though big business borrows much
more in total.
Mr Carroll said an overall comparison should add in fees on the alternative of
bank bills, marketed in minimum parcels of $1 million and favoured by big
business borrowers.
While a bank bill can be split into smaller parcels for small business, it
becomes more expensive. Those bank bills that did end up in the small business

sector generally went to the sizeable concerns at the top end of the small busi-
ness classification.
If one adds the. total fees on loans and bills finance in 2000, the apparent dis-
parity between small and large business is reduced. Small business paid $922
million (a little. over 22 per cent of total bank fees), against $1.17 billion paid
by big business (just under 29 per cent).
'Large business relies on bank bills to finance much of their funding') Mr
Carroll said. 'For the. smaller end, term loans at one to five years are more
convenient because you don't have to roll them over every ninety days.'
Also muddying the. comparison are EFTPOS fees, which are among the
fastest-growing fee areas, averaging 25 per cent yearly growth from 1997
to 2000. By 2000, they comprised 28 per cent of all fees being paid by business
to the banks.
'The Reserve Bank hasn't been able to split the EFTPOS business figures
between large and small business', Mr Carroll said.
This inabUity to allocate almost two-sevenths of all banking fees paid by busi-
ness further obscured the picture on relative banking burdens on large and
small enterprises.
Source:C: Jay 2001, 'Small business fees not unfair, say banks', Australian Financial Review,
14 August, p.40.
• Probably the most challenging survey finding for lenders relates to small
business satisfaction with the service from their financial institution. A
minority of businesses believed that the financial institution was generally
supportive of small business (46 per cent) or cared about them as a
customer (45 per cent). Approximately one in three small businesses
were satisfied that they got value for money in terms of the service
received for the fees paid. Compared with the smaller banks and nonbank
financial institutions, the major banks ranked lower across all of these
measures.
Overall, these findings reveal a picture of a deteriorating relationship between
small business and the major banks in particular. The following would explain
this deteriorating relationship:
• Major banks are making Significant changes to the way in which they provide
services to small business.
• The goal of these changes is a reduction in costs to the bank.
• Small businesses do not like these changes.
A further Significant deterioration in this relationship has probably occurred
since the 1999 survey. Earlier in this chapter, we looked at how the National
Australia Bank recently changed the way in which it organises its business
lending, increasing the cut-off point between centralised accounts and relation-
ship managed accounts from $100000 to $250000. This type of change is a
means for the major banks to reduee their costs of servicing the small business
sector by streamlining and centralising smaller accounts. Similar changes are
being trialled by the Commonwealth Bank of Australia. Neither of these 2001
changes were in place at the time of the 1999 survey, so the next survey will
be interesting in terms of whether small business attitudes to lenders further
deteriorate.
Thepoliticalimportance
ofsmallbusiness
andsmallbusiness
lending
Banks and other lenders are changing the way in which they lend to small
business, and small business generally does not like these changes. Is there
any possibility that government may become involved? The possibility of such
involvement is debatable. Government recognises that small business is politi-
cally important, as is evident in the structures set up by the Commonwealth
Government. At the federal level is a Minister for Small Business and Tourism,
a Department of Employment, Workplace Relations and Small Business, and a
Small Business Consultative Committee (see the 'Industry insight' below). In
particular, the upgrading of the Small Business Consultative Committee in
August 2001 is Significant because it becomes the first committee of its kind
to advise the Minister for Small Business directly on all issues with small
business.
If the banks think they are winning the hearts and minds of small business,
they had better think again. Because the Federal Government's top small busi-
ness adviser reckons they are lazy and soft.
Curt Rendall is chairman of the Government's Small Business Consultative
Committee. He says the mood among small and medium-sized enterprises is
that the banks just don't care. What's more, they are punishing small business
for the failures of big business.
'The banks are policy lazy. They make so much money anyway that they just
take the easy option every time', Rendall says.
Tougher times flowing from the troubled world economy left many fearing
small business would struggle in the next few months. But Rendall, whose
accounting practice services many small businesses, says the mood in the sector
remains upbeat.
'Two clients have gone out and bought other businesses and in the process
have doubled their revenue. I'm just not seeing this downturn in confidence
that's supposed to be out there. But the problem is the banks. There's no ques-
tion they're pulling their heads in. They are vastly contracting their dealings
with small business.'
I 280 Part4 Corporateandbusiness

banks' attitude stems
..."'.....,,:::.:·the past few months. HlH,
. . gun-shy.
ascendancy Within the banks.
.l¢t sound lending deals slip by
. .
the collapses there is a concern that the .•".
down a host of small businesses as well, because the
or customers to the big corporation.
truth in that but it can be exaggerated. The big end
itself, so small businesses are generally left on the
effect from the major corporate failures. But for

problem is when other small businesses die,
'rade with.'
concerned about the banks. He fears they Will throttle
or limiting lending facilities.
see his comments as an exercise in bank-bashing. But
warmed up.
·of the SBCC the question of accesS to finance was very
the banks have a social responsibility. It's not good enough for
" they are just another business.
'1 can't open a bank. You need a licence to mn one. As such, the organisations
with those licences have a duty to the public.
'The small business sector has put the GST introduction woes behind them.
They are getting back to more traditional issues, like access to finance, because
funding growth remains one of the biggest hurdles for business.'
Senior partner with small business specialists Hayes Knight, Greg
the worst may be yet to come from the banks.
Hayes says the banks have sought out higher risk sectors and
rather than introduce a general credit clampdown.
Tourism and retail were two industries under pressure, says Hayes. And they
are two areas where there is an abundance of small businesses. Any further
decline in the economy could see thcbanks get more demanding on operators
in those sectors. . ' :
Source: J. Clout 2001, 'Canberra adviser slams bank Financial Review,
2 October, p.44. "
The day-to-day workings of government also exhibit evidence of an interest

in small business. When, for example, Treasurer Costello announced his New
Business Tax System on 21 September 1999, he issued a special media release to
stress the benefits of the small business initiatives contained in the new tax
system.
Government instrumentalities also have an interest in small business. The
Reserve Bank of Australia is an example. It chairs a Small Business Finance
Advisory Panel, which it established in 1993. According to the bank's Governor,
the panel was formed because 'we were worried that banks had become exces-
sively risk averse and were reluctant to lend to small businesses in the early part
the recovery from the 1990-91 recession' (House of Representatives Standing
Committee on Financial Institutions and Public Administration 1997). The
bank recently published an analysis of small business lending for the House of
Representatives Standing Committee on Financial Institutions and Public
Administration (see Reserve Bank of Australia 1997b). This committee asked
the Governor to respond to detailed questions on small business finance, par-
ticularly regarding the fees that banks and other lenders charge.
While the Commonwealth Government does not have small business finance
as a top five area of interest, that may change if levels of dissatisfaction among
small business continue to rise.
Some background
I work for a bank that is active in lending to small business. My official classifi-
cation is as a business relationship manager. I also have a business banker who
works alongside me. Small business lending in the State has been organised by
my bank into regions, and I am based in one of the northern metropolitan
regions. The offices that I operate out of house a group of nine other business
relationship managers plus twelve business bankers. This means there are
opportunities to discuss any problems or queries with other managers, which
can be very useful for those times when a second opinion is required. We are on
the first floor of a two-story commercial office building and the nearest retail
outlet for our bank is over one kilometre away, so it is quite a different working
environment from being based in a bank branch. For one thing, not many of
our customers would visit us at these offices; generally, we go to the site if a
visit is required.
My bank classifies a small business borrowing as being between $10 000 and
$750000. Those business borrowings that are quite straightforward (for
example, those fully secured by residential property) are managed centrally by
the bank. All other small business borrowings are relationship managed. I am
responsible for a portfolio of 605 different customers. Many of these customers
are related; for example, a small business borrower (constituted as a company)
may have a borrowing, and the husband and wife who own the business may
also be borrowers in their own right via credit cards and housing loans. In that
case, there would be three related borrowers. In my portfolio, 605 different bor-
rowers reduce to 117 different groups of borrowers.
I 282 Pari4: Corporateandbusinesslending I

There is a wide variety of business types in this portfolio, ranging from:
• tradespersons (for example, plumbers, electricians and builders)
• professional people (for example, doctors, lawyers, a veterinarian and a
psychologist)
• service-oriented businesses (for example, a childcare centre and some
printing businesses)
• retailers (for example, lunch bars, a swimming pool shop, a golf course, two
tyre retailers and a furniture retailer)
• manufacturers (for example, a plasticS manufacturer).
My day
8.00-8.10 a.m. Manager's references
My day usually starts around 8 a.m. First, I meet with my business banker and
we go through what are known as the manager's references. This is an online
report of any of my customers' accounts that are overdrawn or irregular. With
the overdrawn accounts, I need to decide whether to pay the 'offending' cheque.
When the amounts of money involved are small and the customer is strong, I
will pay the cheque. In other cases, the appearance of the business on my refer-
ences can be a sign of real credit problems that I will need to address. At the
moment, trading conditions for most of my borrowers are reasonably strong;
over the last year, I have put quite a bit of time into managing my more difficult
borrowers. The result is that my manager's references are usually quite straight-
forward and typically completed in 10 minutes.
8.10-8.30 a.m. Correspondence
I go through my emails, many of which are from within the bank and relate to
administrative issues such as attendance at meetings and upcoming training
courses. There is usually quite a bit of paper-based correspondence. Most is
legal and procedural correspondence from within the bank that relates to
existing loans and recently approved loans. The bulk of this correspondence is
passed on to my business banker for processing.
8.30-9.00 a.m. Telephone call to Credit Management Division
In terms of lending decision-making, I do not have a delegation. This means
that I am not able to approve a loan to any of my customers. Approval has to be
done by staff in the Credit Management Division, who are based at head office.
I and my business banker write up lending submissions, outlining why par-
ticular loans should be approved. We then send them to Credit Management for
a decision. It is pOintless working on a submission that has no chance of
approval, so we tend to spend a good part of each day speaking to Credit Man-
agement staff by telephone to check out particular deals. This morning I have a
lengthy telephone call with Credit Management about a lending proposal for an
existing customer (a carpet retailer) to purchase and relocate to a larger show-
room. My contact in Credit Management is not very enthusiastic about the deal
(continued)
and asks me a lot of questions about how the deal is to be structured. After half
an hour of discussion, I agree to some changes to the deal to strengthen the
bank's position.
9.00-9.15 a.m. Meeting with business banl?er
I go through the details of my call to Credit Management with my business
banker, who then starts work on preparing the lending submission for the
carpet retailer deal. The plan is that I will look at a rough draft of this sub-
mission later in the day. I am assuming that the carpet retailer will agree to the
changes required by Credit Management.
9.15-9.30 a.m. Telephone call to carpet retailer and others
I ring the carpet retailer to check whether I can drop by to discuss progress on
his deal. We make a time for the early afternoon. Given that I will be in the area,
I contact a prospective customer (a childcare centre) that I also want to visit.
9.30-11.30 a.m. Various
I want to read through a lending submission that my business banker prepared
yesterday so I can make the necessary changes, sign off on it and send it to Credit
Management for, hopefully, approval. Unfortunately, my reading is punctuated
by customer calls, queries from my business banker and other interruptions.
Two hours later, I finish processing the lending submission.
11.30-12.30 p.m. Meeting with the senior manager
I have a meeting with the senior manager to discuss my lending targets for the
month ahead. I have to explain why I didn't quite meet my targets for the pre-
vious month. She puts pressure on me to improve my performance. I sense that
she is under pressure from her area manager to achieve ambitious lending tar-
gets for the region.
12.30-1.00 p.m. Lunch
I read the Australian Financial Review and other industry publications.
1.00-2.30 p.m. Visit to the carpet retailer
I could have telephoned the carpet retailer to discuss his deal but decided that
it may be more effective to visit him. I know that he is not going to like some of
the changes that the bank is asking for, so I think it is better to explain these
changes to him face-to-face. The deal is worth $1.5 million and I want to do
everything that I can to make sure it proceeds.
2.30-3.00 p.m. Visit to a prospective customer (a childcare centre)
A proprietor of a childcare centre has called me to check whether I would be
interested in taking over $500000 of loans that are currently provided by
another lender. I have briefly talked the deal through with Credit Management
and they are reasonably positive. I want to visit the childcare centre to obtain a
better feel of how it is .run and so on. The visit is quite straightforward, with the
owner saying all the right things. The reasons given for shifting from the other
institution seem to be credible.
I 284 Pari4: Corporateandbusinesslending

3.00-4.00 p.m. Telephonecalls and email
While I was out, there were a number of telephone calls and emails for me.
Responding always takes more time than I expect.
4.00-5.00 p.m. Lendingsubmissions
I read through the draft lending submission prepared by the business banker. I
am happy with the quality of the submission; it certainly makes the job easier
having a competent offsider. I begin making some notes for the childcare centre
deal based on my visit.
5.00-8.30 p.m. University
I have three units of a Bachelor of Business Degree (Finance and Accounting) to
complete. Going toan evening lecture is definitely a strain after a full day of
work.
Source: Anonymous Business Relationship Manager with a bank.
Atheoretical
basisforunderstanding
lendingto
smallbusiness
For the practising small business lender, it may be surpnsmg to know that
much has been written about theories of small business finance. The current
theories have been significantly developed over the past twenty years, and the
key articles have been published in the top finance and economics journals.
Berger and Udell (2002) have proVided a comprehensive review of these
articles. Most articles have been written by US-based authors and focus on
developments in the US banking system.
Despite this body of theory, there is not much evidence of it being incor-
porated into lending textbooks. Few lending textbooks have been written,
particularly for Australia. Of the limited range of lending textbooks avail-
able, some are solely devoted to lending (see Berry et al. 1993; Bourke &:
Shanmugam 1990; Rouse 1994), while others cover lending as one issue
involved in the management of a financial institution (see Saunders &: Lange
1996; Hempel &: Simonson 1999; Hogan et al. 2001). Consistent across
these different books is a tendency to focus on the mechanics of lending -
calculating ratios, identifying cashflows, assessing risks and so on - rather
than any theoretical basis.
This lack of a theoretical base does the study of small business lending (and
lending generally) a disservice. It leads to a focus on the practical at the
expense of the conceptual, yet the conceptual insights can be particularly
important, especially given the current transformation of small businesss
lending worldwide EFeldman 1997; Mester 1997). The changes are most pro-
found in the United States but are expected to soon transform the banking
systems of other countries. There is evidence of these changes beginning in
Australia. The theories are valuable because they can help us to analyse and
better understand these changes.
It is against this background that we will provide the following overview of
the theory of small business finance. Our starting point is a set of definitions
and explanations of key terms that relate to lending generally:
Asymmetric information. Information about borrowers is typically
asymmetrically distributed, with the borrower being well informed and the
lender typically being less well informed. This can be despite efforts by the
lender to become better informed about the business.
• Credit rationing. In a conventional market for goods and services, the price
of the goods (such as wheat) will adjust so a market equilibrium is achieved
where demand and supply are equated. In credit markets, however, problems
of asymmetric information can cause market equilibrium points to be
reached where supply and demand are not equal. These situations of credit
rationing occur where the lender sets the price of a type of loan at a
particular level and maintains that level despite there being unsatisfied
demand. The reason for this behaviour is that an increase in the lending rate
could have two negative effects, causing a reduction in loan quality.
The first effect is known as an adverse selection effect. Increasing the
price of the loan may mean that the better quality customers leave in
search of lower borrowing costs while the poorer quality borrowers
stay.
The second effect is known as a moral hazard effect. The way that this
effect works is that a rise in the cost of borrowing may cause existing
borrowers to look for higher risk projects in which to invest.
Overall, when a lending institution increases its lending rate on a particular
product, this change will offer the potential for increased return. The existence
of adverse selection and moral hazard effects, however, may lead to a fall in the
actual overall revenue received by the lender. In such a situation, it is not
rational for the lender to increase the loan rate when faced by excess demand;
that i.s, the rate of interest charged on the loan is no longer a mechanism for
allocating loan funds according to the forces of supply and demand. Rather, this
rate of interest is used to minimise the adverse selection and moral hazard
effects. The lender has to use some other mechanism for rationing loans to bor-
rowers.
While these concepts of asymmetric information, adverse selection, moral
hazard and credit rationing are widely used in the theoretical explanations of
credit markets generally, they have particular application to small business
finance markets. The information asymmetries associated with lending to small
business have been widely discussed in the literature and are felt to be more
extreme than those of larger businesses (Berger & Udell 2002). The term
'informationally opaque' has been coined to stress the information asym-
metries associated with lending to small business. The term means that a
lender, as an outsider to a small business, has difficulty in seeing into the busi-
ness and gaining an appreciation of all the information that may be relevant to

the lending decision. It is a feature of a small business that one key person is
typically in control. A lot of the information about the business may be in the
proprietor's 'head', rather than in a form that a lender can readily access. Also,
the quality of small business financial statements can be qUite poor; financial
accounts, for example, typically are not audited. Collectively, these influences
can make it difficult for an outsider such as a lender to understand the true
state of the business.
An important consequence of these information asymmetries is that small
business lenders have an incentive to use credit rationing as a device to manage
their credit risk (Saunders & Lange 1996). There is evidence that credit
rationing appears to be more pronounced among smaller business borrowers
(Eatwell, Milgate & Newman 1998, p. 720). Further, the existence of credit
rationing among small businesses has been a major public policy concern in the
United States, where it has led to small business loan guarantee programs and
bank anti-trust review (Frame, Srinivasan & Woosley 2001).
One response of lenders to the extreme information asymmetries associated
with small business has been to develop a different approach to lending, known
as relationship lending. The essence of relationship lending is that it is based on
a medium- to long-term relationship between the lender and the borrower. This
relationship allows the lender to gather information on the business and its
owner, as well as other information that may affect the ability of the business to
repay the loan. Some of this information is termed hard information, which
typically includes the quantifiable information about the business that is con-
tained in the financial statements. The other type of information is termed soft
information, which includes, for example, information about the character and
reliability of the borrower. The word 'soft' is used because this information is
often difficult to quantify, substantiate and communicate within a lending
organisation (Berger & Udell 2002). In Australia, the phrase 'gut feeling' is
often used to describe soft information.
In a recent review of the empirical studies of small business lending, Berger
and Udell (2002) note the importance of strong lending relationships.
Researchers have measured the strength of these lending relationships in terms
of the relationship's time of existence, its extent, its exclusivity, its degree of
mutual trust and whether a main bank is involved. Measured in these terms, the
stronger the lending relationship, the more likely the borrower is to experience:
• lower interest rates
• reduced collateral requirements
• lower dependence on trade debt
• greater protection against the interest rate cycle
• increased credit availability.
Empirical work by Berger and Udell (1995) established that the borrower-
lender relationship, which is at the centre of the relationship lending approach,
is an important mechanism for reducing the asymmetric information problems
inherent in lending to small business. They found that borrowers with longer
banking relationships pay lower interest rates and are less likely to provide
collateral. They concluded that relationship lending generates important infor-
mation about the quality of the borrower.
Another interesting conclusion from this research concerns the unique
structure of the US banking system. By way of background, the US banking
system is not homogenous. Thousands of smaller banks have operations that
tend to be confined to a particular localised area or community, while some
very large banks have national operations. Researchers have noted that the
smaller community banks are most active in the small business lending
market. These smaller banks also tend to use a relationship lending model. In
many ways, this makes sense: a smaller bank operating in a local community is
ideally positioned to develop a relationship with its small business borrowers
and thus collect the 'soft' information that is a feature of relationship lending.
The larger national banks tend to use a different style of lending. Researchers
such as Frame, Srinivasan and Woosley (2001) have found that these banks are
more likely to employ a more objective approach, which uses, for example,
standard financial statement criteria in making loan decisions. Again, this also
makes sense: the larger banks are often based in major population centres and,
as a result, probably lack the community links of the smaller banks. For the
larger banks, effective implementation of a relationship lending model is more
difficult.
Here, we have used the theory underlying small business lending to explain
why the use of a relationship lending model for small business is reasonably
widespread. In the next section of the chapter, we will provide more detailed
coverage of what a relationship lending model involves. We will also cover the
credit scoring approach. In covering credit scoring, we will again use the theory
of small business lending to explain the implication of credit scoring for the
lender-borrower relationship.
Thedecisionto lendtosmallbusiness
Certain principles of lending are universal, including the ideas that:
• the first way out of any loan should be via cashflow from operations
• the second way out should be from security
• the lender needs to understand all the key risks associated with the first and
second ways out, and mitigate them wherever possible.
While these principles do apply to small business lending, a small business
lender must understand the distinctive nature of the risks involved. Here we
will look at these distinctive risks and consider two different approaches to
making a small business lending decision: a relationship management approach
versus a centralised management approach.
Specialised
risksassociated
withlendingtosmallbusiness
Lending to small business generally involves more risk than lending to medium-
sized and larger business, for a number of reasons. One reason relates to the small
size of the business. We noted earlier that the Australian Bureau of Statistics
I 288 Part4: Corporateandbusinesslending

defines a small business as any business with fewer than twenty employees. Table
9.5 contains information on the numbers of small businesses classified according
to number of employees. The table shows that one-half of all Australian small
businesses are owner-operated without any employees. An additional one-third
of small businesses have between one and four employees. That leaves 16 per
cent of small businesses with between five and nineteen employees.
TABLE 9.5 Total numbers of small businesses classified by number of employees per business,
1999-2000
Number01employees
o(a) 1- 4 5 -19 Tolal
Number of businesses ('000) 542.2 365.7 167.1 1075.0
(a) The owner works in the business without any employees
Source: Australian Bureau of Statistics 2001, Small Business in Australia, cat. no. 1321.0.55.001,
Canberra.
Keypersonrisk
From a lender's point of view, there are risks in lending to such small entities. A
major risk is the so-called key person risk. This is almost certainly going to be
a significant risk for those 50 per cent of small businesses where there are no
employees and the owner is the key person in the business. Consider a situ-
ation where the owner of the business dies or is incapacitated through injury or
sickness. In such cases, the continuing operation of the business may become
doubtful, as would the cashflow on which the lender is relying as the first way
out for repayment of the loan.
While the size of the key person risk can be very high for one-person oper-
ations, it can also be very high for larger small businesses. It depends on how
much the owner has involved other persons in the running of the business. Con-
sider the hypothetical business of an Asian food importer. Fifteen persons are
employed in the business: seven in the warehouse, four to deliver product to
restaurants and shops, and four in sales and office management. The owner
spends one week out of every three travelling through Asia to source product.
He has excellent connections throughout Asia and has been able to negotiate low
prices for a lot of his product lines. The key person risk is high for this business
because the owner has been relatively secretive about his contacts in Asia. No-one
in the business has ever accompanied him on any of his trips and he has not
kept written details of his contacts and agreed pricing over the year ahead.
Thelackofcapital
Small businesses are widely recognised as having a lack of capital (Weaver &
Kingsley 2001), for a number of reasons. Often, lack of capital simply reflects
the limited financial resources of the owner. Establishing a business can be
expensive and the owner may have to rely on a lender to provide the bulk of the
funding for either the purchase or set-up of the business.
A second reason is that the net worth of the owner may be tied up in the family
home. This means the owner may be trying a deliberate strategy to maximise the
amount of business debt because he/she can claim tax deductibility on the
interest. Private debt, in the form of the loan for the family home, does not have
tax deductibility on the interest, so the owner may look to minimise this debt.
A third reason for a lack of capital is that the owner may be funding the busi-
ness via loans to the business rather than through capital. This approach can be
attractive for the owner in that it allows the loans funds to be withdrawn. Capital,
in contrast, generally cannot be withdrawn from the business. Most lenders
would prefer the owner to fund the business via capital rather than loans.
A fourth reason is that the owner may be using a business structure that typi-
cally involves only a small amount of capital. The entity may be structured as a
trust with only a small settled sum (similar to capital in a company), for
example. Alternatively, the business may be structured as a two-dollar company.
Again, the amount of capital is negligible in this case.
A final reason for lack of capital is that the owner may be drawing all the profits
out of the business. This would mean that the level of retained profits is minimal
and makes no Significant contribution to the capital funding of the business.
Whatever the reason for a lack of capital, it means a high level of gearing for
the business. In conceptual terms, this means that the business is exposed to a
high level of financial risk.
A lack of capital often has an impact on a small business when the business
rapidly grows. Not having a significant capital base to fund its expansion, the
business uses short-term working capital to fund expansion. A typical scenario
would be that the business uses its overdraft to fund the growth of various cur-
rent assets such as stock and debtors. In extreme cases, the short-term working
capital can be used to fund longer term assets. Whatever the sequence of
events, a common symptom of overtrading is extreme pressure on the liquidity
of the business.
lack ofa trackrecord

Lenders are usually at their most comfortable when they are lending to
well-established businesses. A history of the business gives the lender the confi-
dence to predict cash flow from operations and, in turn, loan repayments in the
future. Also important is evidence that the ownerlborrower can be relied on to
repay borrowings. This is the important 'character' consideration from the five
Cs of lending: character, capacity, collateral, capital and conditions.
For many small business borrowers, lenders do not have this level of comfort.
The ownerlborrower may be a first-time business borrower without a track record
of having repaid debts. Further, the concept behind the business may be relatively
new and untested in the local market. If the borrower is purchaSing an established
business, then there may be doubts about the ability of the borrower to run that
particular type of business. In this situation, the lender cannot analyse three years
of historical financials for the business, so the cashflow budget projections are
best guesses rather than an extrapolation of a trading history.
I 290 Parl4: Corporateandbusinesslending I

The following examples show when a lack of track record may cause a
problem with repayment of the borrowing.
• A police officer retires and purchases a lunch bar.
• A person returns from a holiday in Canada with an idea to start a business
based on a new retailing concept that has recently been successful in Canada.
The concept involves selling supermarket products (for example, flour, sugar,
cereals and so on) in an unpackaged form. Customers weigh out the
quantities they require and save on the cost of packaging.
• A recently qualified mechanic is looking to import damaged Cadillac cars
from the United States, repair them and sell them in Australia.
Thepoorqualityoftheaccounting
information
The poor quality of the accounting information supplied by small business is a
common theme mentioned by writers on small business lending (see Rouse
1994). Anyone with experience in lending to medium-sized to large businesses
would expect most businesses to prepare the following:
• annual statements of financial position, statements of financial performance and
cashflow statements, prepared in accordance with the relevant accounting standards
• monthly actual statements of financial position and statements of financial
performance
• monthly budgeted statements of financial position and statements of financial
performance for comparison against actual figures
• a yearly cashflow budget
• monthly cashflow statements.
In comparison, much less accounting information is regularly prepared by
small businesses. Typically, a small business prepares only an annual statement
of financial position and statement of financial performance.
Whereas most medium-sized to large businesses have an in-house accountant
to prepare accounting reports, such an employee is more the exception than the
rule with most small businesses. Often the owner of the small business prepares
the financial statements. Given that he/she has many jobs to do, the accounting
information may be prioritised down the list of things to do.
Almost all small businesses have access to an external accountant who can produce
financial statements. This can be expensive, however, so a typical proprietor looks to
minimise the use of an accountant beyond the preparation of annual taxation returns
and annual statements of financial position and statements of financial performance.
As Hey-Cunningham (1998) notes and we will discuss later, the focus in these
tax-driven financials may not match the information in which the lender is interested.
The overall quality of the accounting information supplied by small busi-
nesses is thus generally low. Here, we will explain why this is the case.
Delays in the preparation of financial statements
One reason for poor quality results from delays in the preparation of the finan-
cials. The longer the time period that elapses between the balance date (30 June)
and the delivery of the financials to the lender, the less will be the likely value
of those financials to the lender. This is particularly the case when the financials
are being used for an assessment of the business's liquidity. The quantities of cur-
rent assets and current liabilities are likely to have changed significantly since
the balance date. Unfortunately, many lenders to small business experience long
delays in receiving financial statements, so the value of those financials is ques-
tionable as an up-to-date assessment of the business's financial position.
Emphasis on taxation
A second reason for poor quality accounts is the heavy emphasis on taxation in
the preparation of the accounts. Hey-Cunningham (1998) suggests that many
small businesses border on being obsessed with minimising their tax rather than
on maximising the performance of their business. This focus can lead to a var-
iety of transactions that act to reduce profit so the amount of tax paid is mini-
mised. The owner of a business may decide, for example, to make large
contributions to hislher superannuation account, which acts as a charge on the
profit of the business. This can make the business seem less profitable than it
really is. Another example would be where the business proprietor does not dis-
close certain cash sales, to avoid having to pay tax on those sales.
Reporting freedoms for a small proprietary company
It is common for Australian small businesses to use a company structure. As a
company, a small business has considerable flexibility in the way in which it
must prepare and present its financial accounts. To be more specific, most small
businesses qualify as a small proprietary company under the provisions of the
Corporate Simplification Act 1995. Section 45 A(2) of the Act defines a small
proprietary company as having at least two of the following three requirements:
• for the company and entities it controls, consolidated gross operating
revenue for the financial year of less than $10 million
• for the company and entities it controls, a value of consolidated gross assets
at the end of the financial year of less than $5 million
• for the company and entities it controls, fewer than fifty employees at the
end of a financial year.
Based on discussion on page 267, nearly all small businesses (as the term is
used in this chapter) would be likely to be classed as 'small proprietary com-
panies'. The Australian Bureau of Statistics definition of a small business
involves having a maximum of only twenty employees, which is well under the
fifty employees used to define a small proprietary company. The Reserve Bank
of Australia definition of a small business is based on a maximum borrowing of
$500000, which is argued to roughly correspond with a turnover of $5 million.
Again, this is well short of the $10 million gross operating revenue for a small
proprietary company. In general terms, therefore, nearly all small businesses
operating as a company are also small proprietary companies. Wherever a refer-
ence is made to a small proprietary company in the following discussion, this
should be taken also as a reference to a small business.
The definition of a small proprietary company becomes important in terms of
the accounting information that small proprietary companies are required - or,
perhaps more importantly, not required - to provide. In general terms, small

proprietary companies have considerable freedom in the preparation and pres-
entation of their accounting information. They do not have to have their annual
statements of financial position and statements of financial performance audited.
The absence of compulsion and also the expense involved mean that most small
businesses choose not to have their accounts audited. Lenders thus almost
always, except where they require otherwise, receive un-audited financial state-
ments from their small business customers.
A second area of freedom is that small proprietary companies are not required
to prepare annual financial statements. This is a freedom 'in duplicate' for small
proprietary companies because other larger companies that do have to prepare
annual financial statements must also present them in a comprehensive format.
Broadly speaking, the format includes:
• financial statements, including:
a statement of financial performance for the year
a statement of financial position as at the end of the year
a statement of cashflows for the year
a consolidated version of the preceding statements
• detailed notes to the financial statements
• directors' declaration.
Additionally, larger companies are required to ensure their financial state-
ments conform to the accounting standards published by the Australian
Accounting Standards Board.
So what do all these reporting freedoms mean for the lender to the small
business (that is, small proprietary company)? The answer is that the small
business lender needs to be very careful in how he/she reads and analyses any
financial statements received. Some small business lenders use the phrase
'habitually sceptical' to describe their perception of financial statements. This
seems a reasonable starting point given that these financial statements are typi-
cally not audited, do not necessarily conform to all the accounting standards
and are not in a comprehensive form that includes a cashflow statement,
detailed notes to the accounts and a consolidated set of accounts.
Deception
A fourth and final reason for poor quality financial accounts is deception on the
part of the owner and/or the accountant. Borrowers will inevitably look to pre-
sent their business in the most positive way, but at some point this changes
from being positive to being deceptive. If freedom in the preparation and pres-
entation of financial statements is combined with a desire to deceive the lender,
then the consequences can be disastrous. The financial statements will end up
presenting a picture of the business that is very different from the reality.
Risksandsmallbusiness
failure
A consequence of the high risks associated with small business is a high failure
rate for small business. Hey-Cunningham (1998) gives a thorough overview of
the numbers of small business failures and the reasons for these failures.
Quoting research from within Australia, he provides the statistics on page 294.
• Over 30000 small businesses fail each year.
• One-third of all small businesses fail within the first year.
• Almost another one-third fail in the second and third years combined.
• Three-quarters of all small businesses have failed after five years.
Reasons for failure include:
• the inexperience and incompetence of management
• poor quality accounting and other records
• problems with financial management and liqUidity
• lack of expert advice
• too much reliance on debt funding.
Any lender faced with these statistics would be justifiably cautious about
lending to small business. A lender can mitigate these risks, however. One way
involves having a strong second way out (that is, security), which explains the
preference of many small business lenders to lend against landed security. This
has been an area of intense competition over the past few years. The other way
of mitigating risks involves spending more time in both the initial assessment
and the ongoing management of the loan. The problem for the lender is that
this effort is labour intensive, which means it is expensive. Loans to small busi-
ness are typically small, so the ability to spread these expenses over a small loan
is limited. The move by the Commonwealth Bank of Australia and the National
Australia Bank to centralise and automate their small business lending may be
evidence that they are wanting to focus their lending on small businesses with
the most straightforward and lowest risk.
Twoapproaches
tosmallbusiness
lending
We have mentioned the significant changes that are occurring in small business
lending in Australia. Central to these changes is the push by a number of small
business lenders to increase the proportion of small business customers that are
centrally managed via the use of credit scoring models. This means reducing the
proportion of small business customers that are relationship managed. In the dis-
cussion that follows, we will provide more detail on what these two approaches
to business lending - relationship management and credit scoring - involve.
Therelationship
management
approach
During the 1990s, relationship management was widely used with small busi-
ness accounts. According to the National Australia Bank, the model has been
very successfully used by the bank and was a key factor in the bank's strong
growth over 2000-01. The bank has claimed that the strength of the relation-
ship management approach is that it allows the lender:
... to develop an understanding of their customers' business, in all phases of the
economic cycle, and to offer appropriate solutions to their needs. The relationship
manager draws on the expertise of National specialists in a range of areas such as
treasury, payments, leasing and superannuation to provide business customers
with a fully integrated financial service. (National Australia Bank 2001, p.26)

The relationship manager can develop an understanding of the business by
carefully analysing the business's financials. Some of the financials analysed are
historical in nature. These are the standard statement of financial position,
statement of financial performance and cashflow statement for past accounting
periods. For small business, projections usually involve only cashflow projec-
tions (or cashflow budgets as they are sometimes known).
Analysisofhistoricalfinancials
There are two broad stages in the analysis of historical financials. The first stage
involves preparing the financial statements for analysis. The second stage
involves conducting the analysis using tools such as ratios.
Stage 1: Avoiding garbage in, garbage out
The first stage is important because it is essential that the financial statements
reflect the current state of the business. If they do not, then the second stage of
detailed financial analysis can end up being a case of garbage in, garbage out
(GIGO). The following are examples of GIGO in financial analysis:
• A menswear business has a high level of stock due to a quantity of old stock
being included in the overall stock figure. On the face of it, the liquidity ratio
(that is, the current ratio) for the business is quite strong. In reality, however,
the business has a limited ability to sell this old stock for anything close to its
historical cost. Consequently, the liquidity of the business is far worse than it
appears from a superficial calculation and analysis of the liquidity ratio.
• A transport business has sold one of its trucks. The income generated from
the sale has been included as 'other income' in the statement of financial
performance. The lender has ignorantly included this other income along
with the transport income in calculating the gross margin for the business,
thus significantly overestimating the gross margin of the business.
• The directors of a small technology company have increased the valuation of
the company's technology as shown on the statement of financial position.
This revaluation has resulted, as the other part of the double entry, in an
increased amount of shareholders' funds on the statement of financial
position. Superficially, the gearing of the business appears strong. Given that
the revaluation of the technology is really not justifiable on commercial
grounds, the gearing of the company would remain a major concern.
So how does the lender go about avoiding the possibility of GIGO? It is not
easy to set a strict set of rules to follow, but the following are some thoughts:
• Maintain a critical mindset when considering the financials. The ABC of
criminology - accept nothing, believe no-one and confirm everything - is
too extreme for use with most borrowers, but its value is that it signals the
need for the lender to have an inquiring mind.
• Continually ask whether the financial statements accurately reflect what you
already know about the business. Look at the wages expense, for example.
How many people are employed by this business? Is the wages expense about
right for the number of people employed?
• Get to know the business. One way of doing this is through discussions with
both the owner of the business and the accountant. These discussions should
involve questions, some of which will relate to the financial statements. Ask,
for example, how they arrived at the stock level on the statement of financial
position and whether they did a full stock take or just roughly estimated
stock at 30 June.
A second way of getting to know the business is to visit it. Ask yourself
whether what you see matches what is being presented in figures in the
financial statements. How many delivery vans does the business have in its
carpark? Are these vans owned or leased? Are these vans shown on the
statement of financial position? Some lenders describe site visits as a chance
to 'kick the tyres'. Just as a picture says a thousand words, a site visit can
leave a lender with a comprehensive impression about the business.
A final way of getting to know the business is by researching the
characteristics of similar businesses in that industry
Coming up with the right questions is a skill that develops with experience.
The best lenders have an impressive ability to read a set of financials and
quickly identify the key questions to ask the owner or accountant. They also
tend to make very insightful observations during a site visit. Case study 1 on
Boat Builders Pty Ltd (page 499) provides an opportunity to develop these
important skills.
Financial ratios can be grouped under the following headings:
• short-term liquidity
• business performance
• longer term solvency.
It is useful to consider some of the GIGO issues that arise in using these
ratios. For a small business, GIGO issues are often crucially important in inter-
preting the short-term liquidity ratios. Debtors, creditors and stock are the
major current asset and current liability categories, but they are also often
referred to as traditional soft spots in the statement of financial position. These
numbers can be very 'soft' if they have not been accurately estimated. Take the
case of the stock figure. For many small businesses, the proprietor of the busi-
ness calculates this figure. The accountant will not be directly involved and will
generally take the figure as it is supplied by the proprietor. The quality of this
figure depends on how much work the proprietor has put into his/her esti-
mation at the time of stocktake. Also relevant for the lender is whether the
overall stock figure includes any damaged or old stock.
Similar comments can be made about debtors and creditors. An additional
consideration with debtors and creditors is that of ageing. If a debtor is out to
180 days, then there is a reasonable doubt about whether the business will ever
be able to collect this debtor. For this reason, it may be best to not include this
debtor in the calculation of the business's liqUidity
Business performance ratios need to be carefully calculated. A key issue
revolves around how profit is defined (Hey-Cunningham 1998). Does it include
abnormal items? Is it before or after tax? To what extent has the profit for the

business been 'homogenised'? To illustrate, consider the statement of financial
performance for a service station. There are three potential main sources of
income: fuel sales, shop sales and workshop repairs. If all three sources of
income are grouped together in the statement of financial performance and a
gross margin is calculated, then what does this homogenised gross margin ratio
mean? The ideal way to answer this question would be to have financial perfor-
mance information for each of the three profit centres of the business. This
approach would allow the lender to better understand the underlying profit-
ability of the business.
Longer term solvency ratios for small business are not usually that affected
by GIGO considerations. Their main problem is in their interpretation, which
we will cover in the next section.
Stage 2: Detailed analysis of historical financials
Once the financials are in a form where they reflect the true state of the business,
the next stage involves their detailed analysis. Ratios usually form a major part of
this analysis. We noted earlier that financial ratios are typically grouped as short-term
liquidity ratios, longer term solvency ratios and business performance ratios.
Short-tenn liquidity ratios
Once GIGO issues are dealt with, the calculation and analysis of short-term
liquidity ratios is reasonably straightforward. A word of caution, however: it is
probably not useful to place too much emphasis on the short-term liqUidity
ratios by themselves as a source of information about the business's liquidity.
The inevitable delay between the balance date and the time of receipt of the
financials by the lender plays a big part in redUCing the value of the liquidity
ratios. Perhaps more importantly, the point of these ratios - particularly in the
case of the current and quick ratios - is to provide information about how the
business is managing its overall liqUidity position. Where the borrower has pro-
vided cashflow projections to the lender, these will probably be a better way of
assessing the overall liquidity position of the business, particularly where the
projected figures are reconciled against actual figures on a monthly basis.
Similar caveats can be attached to more specific short-term liqUidity ratios
such as the two turnover ratios (debtors and creditors). Rather than spending a
lot of time calculating and analysing these two ratios, it is likely to be more
useful to obtain an aged listing for each of them. Most small businesses are in a
position to generate such a listing from a standard accounting package that they
use. The advantage of the listing is that it is hopefully up-to-date. It will give
more insight into the ageing of individual debtors and creditors.
Longer term solvency ratios
These ratios can be tricky to interpret in the case of small business customers, which
frequently have low levels of paid-up capital. The result is that the standard longer
term solvency ratios end up taking extremely large values (for example, fixed assets/
shareholders' funds) or extremely small values (for example, shareholders' funds/
total assets).
Capital is generally recognised as having four key properties: it provides a
permanent and unrestricted commitment of funds; it is freely available to
absorb losses; it does not impose any unavoidable servicing charge against earn-
ings; and it ranks below the claims of depositors and other creditors in the
event of wind-up (Australian Prudential Regulation Authority 2001).
Discussion earlier in this chapter highlighted that small businesses are short
of capital for two main reasons: (1 ) they are short of capital due to limited
financial resources or because they do not leave any profits in the business, or
(2) they are using other proxies for capital (such as providing loans to the busi-
ness or using equity in the family home as security for the loan).
If a borrower has no capital, then the lender would conclude that there are no
funds that:
• provide a permanent and unrestricted commitment of funds
• are freely available to absorb losses
• do not impose any unavoidable servicing charge against earnings
• rank below the claims of depositors and other creditors in the event of
wind-up.
The lender would then need to assess the risks resulting from this lack of capital.
If a borrower is using other proxies for capital, then the lender would need to
ask how well these proxies substitute for capital. Loans to the business are
likely to have the four key properties of capital. These loans are likely to be
withdrawable, for example, whereas capital is a permanent commitment of
funds. The lender may choose to attach various conditions to the borrowing so
these directors' loans behave more like capital. Table 9.6 provides a summary of
some of the main conditions that can be used.
TABLE 9.6 Conditions imposed on a borrower where the borrower is funding the business with loans
rather than with capital
Thecondition
usedinIhelending
agreemenllomakeIheowner'sloan
Properlyofcapital behavemorelikecapital
1. Provides a permanent and unrestricted Owner is not allowed to withdraw the loan
commitment of funds. without the prior approval of the lender.
2. Is freely available to absorb losses. Not applicable
3. Does not impose any unavoidable servicing A limit is set on the interest rate that the
charge against earnings. owner can be paid on the loan.
4. Ranks below the claims of depositors and The owner's loan is subordinated to other
other creditors in the event of wind-up. depositors and creditors in the event of
wind-up.
Equity in the family home is sometimes used as a proxy for business capital,
through being provided as security. A house provided as security is clearly not a
form of funding for a business, so the business still needs to borrow. The differ-
ence is that the lender now has some security to be used against that borrowing.
The family home does not satisfy the first and third properties of capital; it just
I 298 Pari 4: Corporateandbusinesslending I

provides a mechanism to meet losses if the business experiences difficulties.
The lender thus needs to carefully assess the financial risk faced by the bor-
rower. The existence of security in the form of the family home does nothing to
limit that financial risk.
Business performance ratios
Business performance ratios are an important source of information about small
business. The gross margin ratio is of particular interest because it is relatively
uncontaminated by outside influences. To be of most use, however, gross mar-
gins should be calculated for the relevant profit centre rather than globally for
the business. The net margin ratio, in contrast, is often less useful to the extent
that it is influenced by various expenses that may be linked to tax-based strat-
egies (such as superannuation contributions).
Analysisofcashflow
projections
One approach to the perceived problems with the historical financials of small
businesses is to focus more on the business's cash flow projections (sometimes
also called cash flow budgets, although the former term will be used here). It is
important to stress that cashflow projections are very different from cash flow
statements.
There are a numher of advantages of relying on cashflow projections in small
business lending:
• A cashflow projection is based entirely on cash movements, so it clearly
indicates the financing requirements of the business. A cash flow projection is
typically used to indicate a peak level of debt that a business will have in its
overdraft account over a year. This can be an important role for the cashflow
projection, given that overdraft lending makes up around half of all small
business lending (Reserve Bank of Australia 1994).
• Cashflow projections can be a tangible way of monitoring the progress of a
business, for both the proprietor and the lender. In simple terms, a cashflow
occurs when there is a movement of funds into or out of an account. In most
cases, the major cashflows will be in or out of the business's overdraft
account. Both the lender and the borrower are typically in a good position to
follow these movements via electronic access to overdraft account
information. In addition, these cashflows are relatively straightforward to
understand because they are simple movements of funds in and out of an
account. Profit is an alternative to cashflow as a measure of business
performance, but it has the disadvantage of not being as easy to understand.
As an accounting concept, profit is based on a number of accounting
assumptions. Its calculation can involve noncash items such as depreciation.
These assumptions can mean that profit is a more difficult and less tangible
measure of a business to track, for both the proprietor and the lender.
• Cashflow projections have a particular advantage where the lender wants to
tightly manage the account given the pOSSibility of further deterioration in
the account and ultimately default. The goal of the tight management may be
to enforce an upper limit on the exposure of the lender to the borrower.
Based on available security, the lender may want to limit the exposure to the
business to $500000, for example. A typical cashflow projection would be
divided into units of months over a calendar or financial year. It is a
reasonably straightforward matter for the lender to compare monthly actuals
against budgeted figures as a way of tightly controlling the account.
Relying heavily on cashflow projections also has its disadvantages. The
assumptions underlying a cashflow projection can be very unrealistic, possibly
as the result of deliberate manipulation of the assumptions by the borrower.
Alternatively, the borrower might have been overly optimistic - a problem that
often combines with a lack of commercial experience. In some instances, unre-
alistic cashflow projections have been unflatteringly referred to as 'dream
sheets'. The proprietor is so optimistic that the cashflow projections resemble a
dream more than reality.
Establishing the reality of the assumptions underlying the cashflow projec-
tions can be a particular problem where the business is new. A new business
means that there is no track record on which to judge the assumptions under-
lying the cashflow. In such cases, it is advisable to use a checklist to analyse the
cashflow in detail. An example of such a checklist follows in table 9.7.
TABLE 9.7 A five-stage checklist for analysing cashflow projections
1. The origins of • Who prepared the cashtlow?

the cashtlow • Why was it prepared?
• What were the relative inputs of the customer and the accountant in
generating the cashtlow?
2. The starting What is the opening bank balance? It can be the subject of
point of the manipulation. It can easily be confirmed, however, by reference to
cashflow account balance information.
3.lntemal Mistakes with spreadsheet formulas Caneasily be made, so it is essential

numerical to always check numerical consistency. A cross-check of totals is a good
consistency overall guide to numerical consistency.
4. Validity of the A cashflow is almost meaningless without knowledge of the assumptions

underlying on which it has been based.
assumptions • Has the accountant (or customer) written down the key assumptions
that have been made?
• How does the accountant (or customer) feel about the underlying
cashflow? Is it seen as optimistic, pessimistic or realistic?
• Have past financials been used as a basis for generating the cashtlow?
• In particular, how do sales figures relate to past years?
Apply selected ratios·(for example, gross margin and net margin) to the
cashflow figures and compare with previons years ratios. Check the
validity of the fixed costs. Determine whether any extraordinary items
have been left oul.
5. Critical • Has the accountant (customer) undertaken any sensitivity analysis?

consideration of • Has this senSitivity analysis been thorough enough to identify the
sensitivity critical assumptions of the cashflow?
analysis • What sensitivity analysis should be undertaken?

Assessment
ofrisks
Lending to small business is very risky. High rates of small business failure are
the tangible evidence of these risks. The lender needs to understand all the risks
involved in a small business deal and mitigate them where possible. Earlier in
the chapter, we identified the following distinctive risks associated with lending
to small business:
• key person risk
• lack of capital
• lack of a track record
• poor quality of accounting information:
delays in the preparation of financial statements
an overemphasis on taxation
reporting freedoms for a small proprietary company
deception.
Theimportance
ofsecurity
Some types of lending, such as project finance, do not greatly rely on security.
In small business finance, however, security can be a very important consider-
ation in deciding whether to approve a deal. Over the past five years, lenders
have shown a strong and increasing preference for small business borrowers
who are able to offer residential security. This security is seen as a way of offset-
ting the other risks associated with lending to small business. It also has the
added advantage of minimising the time reqUired to make a decision on the
deal: if the second way out is strong, then relatively less time needs to be put
into analysing and ultimately feeling confident with the first way out.
Problemswiththerelationship
management
approach
For the relationship manager to make a decision on a small business deal can
take time: lots of questions get asked of the proprietor/accountant; the finan-
cials (historical and projected) are analysed in detail; and risks and risk miti-
gants are carefully detailed. Once the loan is approved, the ongoing
management can be quite labour intensive.
Another problem with relationship lending relates to credit quality. As dis-
cussed previously, an important feature of relationship lending is the role played
by 'soft' information that is collected by the loan officer. Berger and Udell
(2002) suggest that use of a relationship lending model should involve a greater
delegation of lending authority to an institution's loan officers. A consequence
can be that the institution will be exposed to greater credit risks because 'soft'
information, as discussed previously, is notoriously difficult to quantify, sub-
stantiate and communicate within a lending organisation. The institution often
responds to this risk by allocating more of its resources to reviewing the work
of its loan officers and measuring loan quality. This can be quite expensive for
the institution.
These various problems lead to a key question: does the use of a relationship
lending model in small business lending generate the maximum return for
shareholders? Judging by what a number of small business lenders are doing,
the answer is 'no'. In comparison, a credit scoring approach offers a way of cut-
ting costs and increasing returns.
Thecreditscoringapproach
What exactly does a credit scoring approach to the management of small busi-
ness accounts involve? Typically at its centre is a mathematical model, which is
the credit scoring model. Various pieces of information about the borrower are
inputs into the mathematical model. This information can include the credit
history of the borrower, various financial information/ratios, the current level of
borrowing and years of experience in the industry. The output from the model
is a single number that measures the likely future loan performance of the bor-
rower (Feldman 1997).
The lender can use this credit score in a number of different ways. Some
lenders may use credit scores in an automated process that approves or rejects
loan applications; others may use credit scores as extra information to be
included as part of the overall credit assessment.
The major US banks began experimenting with credit scoring of small busi-
ness loans in the early 1990s. Now, almost ten years later, some Australian
banks are starting to credit score their small business loans. This gap of a
decade roughly corresponds with other estimates of how far Australia lags
behind the US financial system. Battelino (2000), for example, has calculated
that the Australian financial system is fifteen years behind that of the United
States. Given this ten-year gap, the US experience with credit scoring of small
business loans is used here as an important indicator of how things are likely to
develop in Australia.
A background
to smallbusiness
lendingin theUnitedStates
What constitutes a small business in the United States is slightly different from
the definitions used in Australia (and discussed earlier in this chapter). A small
business is defined in the United States by the Small Business Administration as
an enterprise employing fewer than five hundred employees (compared with
the cut-off of twenty employees used by the Australian Bureau of Statistics). By
the US definition, small businesses comprise 99 per cent of the twenty-three
million nonfarm US firms. Despite the potentially large size of a small business
in the United States, a small business loan is conSistently defined by researchers
as a loan of up to $100000. For this reason, Frame, Srinivasan and Woosley
(2001) note that a $100000 business loan is probably better described as a
small loan to a business rather than a small business loan. The classification of
small business loans being less than $100000 nevertheless remains in wide-
spread use in the United States and will be continued here.
A clear point of difference between the US and Australian banking systems is
the number of banks. At 30 September 2001, there were 8149 insured commer-
cial banks in the United States, contrasting rather dramatically with the
fifty-one banks that operated in Australia around the same time. Making up the

large numbers of US banks have been those banks with a small number of
branches (in some cases, only one) and a distinctive focus on their local com-
munity. Hempel and Simonson (1999) suggest that these local banks may now
be on the endangered species list as their number continues to decline. At the
same time, there have been increases in the size of larger multiple-office
banking institutions.
The significance of the local banks is that they have traditionally been the
main source of finance for small business (Frame, Srinivasan &: Woosley 2001).
Moreover, they have provided this finance through the use of a relationship
management approach. As we will discuss later in this section, however, the
role of these local banks is now changing qUickly with the larger banks'
increasing use of a credit scoring approach.
Thepastandpresentuseofcreditscoringin theUnitedStates
Credit scoring has been widely used in decision-making on US consumer loans
since the early 1990s. The current industry standard is for credit scoring of con-
sumer loans to be fully automated (Eisenbeis 1996). Despite the initial success
with credit scoring of consumer loans, there was a feeling among some partici-
pants in the industry that it would not be possible to extend credit scoring to
business loans. Business loans were felt to be too complex, heterogeneous and
varied in terms of documentation. A number of factors nevertheless collectively
created a push to develop credit scoring of small business loans (Eisenbeis
1996).
• Cost savings. Competition in the banking industry leading to shrinking
margins increased the pressure to reduce costs. The manual credit analysis of
business loans is a labour-intensive, time-consuming and, consequently,
expensive process. Mester (1997) reports that a typical loan approval process
takes about two weeks and involves around 12.5 working hours per small
business loan. Credit scoring offered the potential of reducing this time to
under an hour.
• Availability of databases. Commercial entities such as Dunn &: Bradstreet
provided large-scale databases on which credit scoring models could be
tested.
• Political reasons. There was a desire in the United States to increase lending
to small business. One way of doing this involved securitisation, but a
precondition for securitisation was a better measure of risk among business
borrowers. Credit scoring offered a way of quantifying this risk.
• Changes in government regulations. The US Government relaxed some of the
regulations relating to securitisation of small business loans, making
securitisation and the associated use of credit scoring techniques more
attractive to lenders.
The push to develop credit scoring of small business loans in the United
States over the past decade seems to have been a success. In 1997, two hun-
dred of the largest banking organisations in the United States were given a
survey (Mester 1997). Sixty-one of the ninety-nine institutions that responded
to that survey indicated that they were credit scoring their small business
loans - a significant rise from the 23 per cent in 1995. While more recent
figures are not available, it would seem that the growth in the take-up of small
business credit scoring has continued. Authors such as Frame, Srinivasan and
Woosley (2001) and Mester (1997) suggest that credit scoring is causing a
transformation in small business lending. Before looking at what this trans-
formation involves, we will examine the structure of these credit scoring
models.
ThestructureofUScreditscoringmodels
While the structure of credit scoring models is in the process of ongoing devel-
opment, something can be said about the recent structures and possible future
developments. One of the first points to make is that many financial institutions
lack the in-house expertise and data to develop a model themselves. Eisenbeis
(1996) identified four companies as being the key players - Fair Isaac,
CCN-MDS, TRW and Dunn 6;[ Bradstreet - and examined each of the four
models. Mester (1997), in providing information on some of the different credit
scoring models in use, makes the following points:
• At least 30000 applications are needed to develop a model for small business
loans.
• Fair Isaacs typically starts with fifty variables and, from these, attempts to
find the combination that most accurately predicts loan repayment.
• The final combination usually involves ten variables.
• The statistical method used in a credit scoring model ranges from the more
traditional linear probability, logit, probit and discriminant analysis models,
through to options pricing theory and neural networks.
What are the ten key variables which typically feature in Fair Isaacs' credit
scoring model? This is where the story becomes very interesting, as the
following quote indicates:
FICO [Fair Isaac] asserts that augmenting data on the owner of the firm with very
basic information obtained from a loan application and a business credit bureau,
such as past credit repayment experience collected by Dun & Bradstreet, produces
a reliable credit score. Perhaps more importantly, FICO claims that data which had
heretofore received much scrutiny in the traditional underwriting process, such as
ratios from financial statements, are not crucial in determining the repayment
prospects of the small firm. In fact, FICO's most popular small business scoring
system does not require the small firm to provide financial statements. (Feldman
1997, p. 4.)
For anyone with practical experience in small business lending, this is likely
to be a perplexing if not a shocking finding. To suggest that detailed analysis of
financial statements may not be that relevant to assessing credit risk is to turn
the existing approach to small business lending on its head. But is this such a
surprising finding? Earlier in this chapter we mentioned the poor-quality
accounting information typically supplied by small business to lenders. Perhaps
Fair Isaac's findings reflect these information quality problems. This would seem
likely, given that Fair Isaac have also found that the quality of the accounting
304 ParI4: Corporateandbusinesslending I

information is directly correlated to the size of the company (Eisenbeis 1996).
To be more precise, 'the smaller the company, the lower is the predictive content
of company financials as compared with the principal's financials' (Eisenbeis
1996, p. 275).
This finding also tallies with a more recent and substantive piece of research
by Kallberg and Udell (2002). They found that if you were keen to know how
likely a creditor company was to repay money owed, then analysis of the bor-
rower's financial statements would not be the best place to start. How regularly
the borrower has been paying its creditors over the last year is likely to give you
a much better predictive variable.
Changes
in creditscoringandsomepredictions
A number of researchers have reported some fascinating findings associated
with the move in the United States to credit scoring of small business lending.
These findings have a strong link to the theoretical framework of small business
lending covered earlier in the chapter. Remember that this framework involves
concepts of information asymmetries, credit rationing, moral hazard and
adverse selection.
The following is a summary of the major findings to date, starting with a
paper by Frame, Srinivasan and Woosley (2001). These authors examined
the use of credit scoring by the top two hundred commercial banks. They
found that when one of these banks changed over to credit scoring of its
small business loans, on average it was able to increase its small business
lending by $4 billion. Their conclusion was that credit scoring seems to
achieve this by reducing the information asymmetries between the lender
and the borrower. This means that the extent of any credit rationing should
be reduced.
Akhavein, Frame and White (2001) established that the first users of credit
scoring were the larger national banks (rather than the smaller community
banks) and also those banks located in New York. This finding seems to be con-
sistent with the economies of scale associated with the adoption of the credit
scoring technology.
In an innovative study, Frame, Padhi and Woosley (2001) found that while
the adoption of a credit scoring method has led to increased levels of small
business lending overall, the effect is more pronounced in lower to medium
income levels. The use of credit scoring in a low to medium income area has
resulted, on average, in an increase of $16.4 billion in small business lending-
two and a half times the effect in a high income area. The authors suggest that
credit scoring achieves this by reducing information asymmetries, which seem
to be most pronounced in lower to medium income areas. These areas have
been 'historically bypassed because of their questionable economic health'
(Frame, Padhi &1 Woosley 2001, p. 1).
On a more pragmatic note, Mester (1997) notes the reduced cost of lending
resulting from the use of credit scoring. For a commercially supplied credit
scoring system, the cost per loan can be as high as $10 but will reduce to $1.50
" -
per loan if volumes are large. This would seem to be much less than the cost
inherent in twelve and a half hours of relationship manager time required in a
typical loan approval.
Given these changes so far, what is the likely future for small business
lending in the United States? In attempting to predict the future, it is best to
start with a caveat. Credit scoring of small business loans is still a relatively new
phenomenon. Some time will need to elapse before it is possible to claim it as a
success over the long term.
One prediction is that the small business lending market in the United States
will end up being like the credit card market (Feldman 1997), eventually char-
acterised by the following:
• a lack of any face-to-face contact between lender and borrower
• simple online application forms and very short approval times
• the possibility of large geographic separations between lender and borrower
• mail-outs of pre-approved facilities to prospective customers who have been
identified through processing commercial databases using a credit scoring
model
• cost reductions leading to increased competition and consequent price
reductions
• the dominance of the lending market by a few large lenders (similar to the
top ten credit card lenders accounting for over half of that market) who
operate nationally and are able to exploit economies of scale from the
technology.
From the perspective of the smaller community-oriented banks, which have
traditionally dominated the small business lending market, this is a sobering
prediction. Small business lending using a relationship lending model has been
a strength of these banks over the larger national banks. The concern is the
extent of the change that will be forced on the smaller community banks as
they lose market share to the larger national banks.
For the large national banks, which are likely to end up as major players in
the small business lending market, there will be a number of advantages.
Credit scoring models provide much greater accuracy in the measurement of
small business credit risk, which should flow on to the pricing of this risk.
Feldman (1997) reported that Wells Fargo, since implementing credit scoring,
has moved to price its small business customers anywhere between the refer-
ence rate plus 1 per cent to the reference rate plus 8 per cent. Lenders using
a relationship lending approach do not usually differentiate pricing to this
degree.
The larger national banks arc unlikely, however, to have this market all to
themselves. Feldman (1997) suggests that already there are signs that nonbanks
such as American Express, AT&T and the Money Store are moving to target
small business borrowers using credit scoring technology.
Whichever large institutions end up dominating this market, they arc
likely to have a better understanding and pricing of credit risk. This should
make securitisation of their small business debt relatively more straight-

forward. Already there appears to be a significant growth in securltlsation
of small business debt linked to the introduction of credit scoring models
(Feldman 1997).
Implications for Australia
Small business lending in Australia appears to be on the verge of significant
change. A number of major banks, which are the dominant lenders in this
market, have moved to centralise their lending to some small business bor-
rowers. While credit scoring is not in widespread use by the major banks, it is
not difficult to imagine it becoming a standard feature in the near future. All the
reasons given for the rapid growth of credit scoring in the United States also
seem to apply to Australia. Further, some banks in Australia, such as Citibank,
will be able to leverage off their US experience with credit scoring; plus, the
commercial vendors such as Dun &: Bradstreet and Fair Isaac are already
looking to market their product into Australia. Credit scoring of small business
loans may be the norm in five years.
Summary
1. What is a small business? What are some of the main characteristics of the
market for small business lending in Australia?
A small business is usually defined as a business with total loans of less than
$500000. Lending to small business in Australia is dominated by the major
banks who provide three main types of finance: floating rate finance, fixed
rate finance and bill finance. Competition among the major banks and other
financial institutions is intense. In an attempt to reduce costs, the major
banks are increasing the proportion of small business customers that they
manage centrally (rather than through face-to-face contact). Perhaps as a
result of these changes, surveys indicate deteriorating attitudes of small busi-
nesses towards their lenders. There is evidence of increasing political interest
in small business lending issues.
2. How do the concepts of asymmetric information, credit rationing, adverse
selection and moral hazard relate to the theory underlying small business
finance?
In lending to small business, there is asymmetric information because typi-
cally the borrower has much better information about the business than has
the lender. This asymmetry, combined with adverse selection and moral
hazard effects, can lead to credit rationing - that is, a situation where not
every business that wants to borrow at the current price can do so.
3. What are the distinctive risks associated with lending to small business?
The wide range of different risks include key person risk, lack of capital, lack
of a track record and the poor quality of the accounting information. These
risks are often linked to the high rate of failure of small businesses.
4. What are the main characteristics of a relationship managed approach to
small business lending?
In a relationship managed approach, a lender looks to develop a relationship
with the borrower over time and, in the process, gather relevant information
about the business. Part of the relationship manager's work involves ana-
lysing financial statements. Much thought must go into financial analysis for
it to be of use in identifying the risks of lending to the business.
5. What are the main characteristics of a credit scoring approach to small
business lending?
A credit scoring approach involves inputting different information about a
borrower into a statistical model, which then generates a credit score. In a
fully automated process, the credit score has to be above a certain level before
the loan is approved.
6. How is lending to small business in Australia likely to change over the next decade?
Probably the best indication of likely changes in small business lending in
Australia is the US experience of the past five years, over which time small
business lending has been transformed in that country. The transformation
has meant that small business lending in the United States now resembles
credit card lending. Loan approvals are automated through the use of credit
scoring and major national banks dominate this market. The use of credit
scoring seems to have reduced the information asymmetries that have been
a feature of lending to small business.
adverse selection, p. 286 credit scoring model, moral hazard, p. 286

asymmetric information, p. 302 overdraft, p. 269
p. 286 first way out, p. 288 prime lending rate,
bill finance, p. 269 fixed rate finance, p. 269 p. 270
business performance, floating rate finance, relationship manager,
p. 296 p. 269 p. 272
capital, p. 289 fully drawn advance, residentially secured
cash rate, p. 270 p. 269 loans, p. 275
cashflow budget, p. 299 garbage in, garbage out second way out, p. 288
cashflow projections, (GIGO), p. 295 security, p. 271
p. 299 hard information, p. 287 short-term liquidity, p. 296
cashflow statements, indicator lending rate, small business, p. 267
p. 299 p. 270 small proprietary
central management, informationally opaque, company, p. 292
p. 273 p. 286 smaller community banks,
credit assessment, key person risk, p. 289 p. 288
p. 275 larger national banks, soft information, p. 287
credit rationing, p. 286 p. 288 soft spots, p. 296
credit scoring, p. 275 longer term solvency, yield curve, p. 271
p. 296

Discussion
questions
1. Distinguish between 'hard' and 'soft' information about a small business.
Give seven different examples of soft information about a small busi-
ness. If you had to choose, would you prefer to use hard or soft infor-
mation in making a lending decision to a small business?
2. Go to the website for Fair Isaac (www.fairisaac.com). What information
can you find on the role that Fair Isaac plays in developing credit
scoring models for small business lending applications?
3. The National Australia Bank's 'Business information form' at www.national.
com.aulBusiness_Solu tions/O,1194,00 .html specifically requests the sub-
mission of a cashflow budget. Why do you think the National Australia
Bank places so much emphasis on a cashflow budget in assessing a loan
to a small business?
4. Explain in your own words what you understand by the phrase 'asym-
metric information problems'. Choose a large business that you know
something about and comment on the information asymmetries that
may arise for a lender to this business. Choose a small business that you
know something about and comment on the information asymmetries
that may arise for a lender to this business. Do you think information
asymmetries are more or less pronounced with large businesses?
S. Read the two articles in the 'Industry inSight' on page 277. Comment on
whether you find the argument of the Australian Bankers Association
convincing. Overall, do you think that the banks' small business fees are
unfair?
6. Refer to the 'A day in the life of ... ' box on page 282. How do you think
this 'day' would change if the bank concerned moved from using a
relationship lending model to a credit scoring model?
7. Explain whether you feel it is an advantage to be classified as a 'small
proprietary company' under the Corporate Simplification Act. What
impact do you think a borrower being a small proprietary company
would have on a lender's attitude to that borrower?
References
andfurtherreading
Akhavein, J., Frame, W. S. & White, L. J. 2001, 'The diffusion of financial innovations:
an examination of the adoption of small business credit scoring by large banking
organisations', Federal Reserve Bank of Atlanta Working Paper Series, Working
Paper 2001-9, pp.1-25.
Australian Prudential Regulation Authority 2001, Australian Prudential Standard 111:
Capital Adequacy, www.apra.gov.au/Policy/loader.cfm?url=/commonspotisecuri tyl
getfile.cfm&PageID=684, accessed 29 December 2001.
Battellino, R. 2000, 'Australian financial markets: looking back and looking ahead',
Reserve Bank of Australia Bulletin, March, pp. 16-25.
Berger, A. N. & Udell, G. F. 2002, 'Small business credit availability and relationship
lending: the importance of bank organisational structure', The Economic Journal,
112(477), pp. F32-F53.
Berry, A., Faulkner, S., Hughes, M. & Jarvis, R. 1993, Bank lending: Beyond the
Theory, 1st edn, Chapman & Hall, London.
Bourke,P & Shanmugam,B. 1990,An Introductionto Bank Lending,Addison-Wesley,Sydney.
Eatwell, J., Milgate, M. & Newman, P. (eds) 1998, The New Palgrave: A Dictionary of
Economics, Macmillan, London.
Eisenbeis, R. A. 1996, 'Recent developments in the application of credit-scoring
techniques to the evaluation of commercial loans', IMA Journal of Mathematics
Applied in Business and Industry, 7(4), pp.271 -90.
Feldman, R. 1997, 'Small business loans, small banks and a big change in technology
called credit scoring', Federal Reserve Bank of Minneapolis, The Region, 11(3),
pp.1 9-25.
Frame, W. S., Padhi, M. & Woosley, L. 2001, 'The effect of credit scoring on small
business lending in low- and moderate-income areas', Federal Reserve Bank of
Atlanta Working Paper Series, Working Paper 2001 -6, pp. 1-24.
Frame, W. S., Srinivasan, A. & Woosley, L. 2001, 'The effect of credit scoring on
small-business lending', Journal of Money, Credit and Banking, 33(3), pp.81 3-25.
Hempel, G. H. & Simonson, D. G. 1999, Bank Management: Text and Cases, 5th edn,
John Wiley & Sons, New York.
Hey-Cunningham, D. 1998, Financial Statements Demystified, 2nd edn, Allen &
Unwin, Sydney.
Hogan, w., Avram, K. J., Brown, C., Ralston, D., Skully, M., Hempel, G. & Simonson,
D. 2001, Management of Financial Institutions, John Wiley & Sons, Brisbane.
House of Representatives Standing Committee on Financial Institutions and Public
Administration 1997, Reserve Bank of Australia's annual report 1996-97:
discussion, Canberra.
Kallberg, J. G. & Udell, G. F. 2002, 'The value of private sector credit information
sharing: the US case', Paper presented at the Australasian Finance and Banking
Conference, Sydney, 17 December.
KPMG 2001, 2001 Financial Institutions Performance Survey, www.kpmg.com.au/
contentllndustries/lndustries/Financial_Services/Financial_lnstitutions_Performance_
Survey-2001 , accessed 6 December 2001.
Mester, L. J. 1997, 'What's the point of credit scoring?', Federal Reserve Bank of
Philadelphia Business Review, September/October, pp.3-16.
National Australia Bank 2001, Annual Review 2001, Melbourne.
Reserve Bank of Australia 1994, 'Bank lending to small business', Reserve Bank of
Australia Bulletin, April, pp.29-37.
Reserve Bank of Australia 1997a, 'Recent developments in small business finance',
Reserve Bank of Australia Bulletin, April, pp.1 -5.
Reserve Bank of Australia 1997b, 'Small business lending', Reserve Bank of Australia
Bulletin, October, pp. 6-13.
Reserve Bank of Australia 1999, 'Recent developments in interest rates on bank
lending', Reserve Bank of Australia Bulletin, April, pp.1 -7.
Reserve Bank of Australia 2001, 'Statement on monetary policy', Reserve Bank of
Australia Bulletin, May, pp. 1-50.
Rouse, C.N. 1994, Bankers'Lending Techniques,The Chartered Instituteof Bankers,London.
Saunders, A. & Lange, H. 1996, Financial Institutions Management: A Modern
Perspective, 1st edn, Irwin, Sydney.
Weaver, P. M. & Kingsley, C. 2001, Banking and Lending Practice, 4th edn, Lawbook
Company, Sydney.
Yellow Pages@Small Business Index 1999, Attitudes to Banks and Other Financial
Institutions, www.sensis.com.au/lnternetismall_business/ybpi/smeiypbisC01 9.pdf,
accessed 10 September 2002.

International
lending
Learningobjectives
After readingthis chapter,you should be ableto:
1, overviewthe structureof the internationalfinancial

markets
2, applythe principlesof internationallending
J trade financeproductsin perspective
4, explainthe importanceof internationaloperations

to financialinstitutions
5, demonstratethe processof country risk analysis,

Introduction
International lending forms the heart of the international financial system. The
raising of funds and the lending of those funds allows for intermediation across
all financial markets of the world. In addition, corporate activity creates a com-
petitive environment where there is huge demand for funds. Accordingly, rates
are kept low for borrowing and are higher for the investor due to the lack of
total supervision from local or country central banks. In this chapter, we will
look at the principles of international lending and how trade finance forms the
core component of the total lending system. This information builds on the
knowledge of domestic and corporate lending discussed in earlier chapters.
In addition, we must note, given the interbank market, that the physical
trading activities in a value and volume sense are a small part of the market as
a whole because trading in a wholesale market by member banks is greater than
the retail segment.
Overview
ofinternational
lending
In the study of international banking and lending, it is vital to understand the
international financial system's structure and how it works. It is vital in this
ever-changing world to put actions, change and events into a historical
framework.
The international financial system is dynamic and change is the norm.
Accordingly, an understanding of the factors at play is essential for survival. The
major factors are the payments system, world trade and finance, the availability
of funds and country risk analysis. The system as we know it today is relatively
young in terms of world history and has evolved constantly since its inception.
The business environment of today embraces globalisation, the financial
markets operate across borders freely and capital is recognised as a scarce
resource that is available on the basis of competition, need and ability to pay
(Eiteman, Stonehill &: Moffett 1998).
International
financialsystem
The modern financial system began back in the 1950s; the world had recovered
from the Great Depression and was in the post-World War II boom. The system
in the early years was protected by international agreements to avoid the pro-
tectionist policies of the pre-war years. The system evolved from the Bretton
Woods conference of 1944. Forty-four countries attended the conference and
agreed on the foundations of the post-war international monetary system. Much
has been written on the evolution and participants of the international financial
system, and we urge you to become familiar with this background. In this
chapter, we are concerned with only (a) the fact that the international markets
exist and (b) supply liquidity for the expansion of the loan portfolio within a
financial institution.

The international financial markets are made up of the foreign exchange
market, the global capital market, the international bond market, the inter-
national equity market, the euro market and the futures and swaps markets.
Accordingly, a truly international financial institution is involved in a wide var-
iety of financial activities, which will entail operations in the above markets and
vary from the purchase and sale of foreign currency to participation in syndi-
cated advances. The activities in general are similar to the domestic operations
of the entity but vary in terms of risk, exposure and complexity.
The euro market is the predominant market of the international financial
system; in some ways, it is an accident of history and a direct result of the aid
offered by the United States to a ruined Europe after World War II and of the
regulatory regime conducted by the United States at the time (Shapiro 1992).
An item can be classed as a euro market transaction when a third country cur-
rency is arranged between other parties that are resident outside the country of
origin and ownership of the funds is separate from the country of currency. It
consists of two components:
1. the primary market, which forms the basis of the whole market and supplies
the basic liquidity within the total euro market. Depositors are normally
wealthy individuals, large corporations, central banks and so on.
2. the interbank market, which is the wholesale market where the liquidity
derived from the primary market finds its way to a borrower. The deposit
may weave its way through several intermediaries before final allocation to a
borrower.
Banks and financial institutions operate in the international markets because
they have expertise in one or more of the following functions:
• foreign exchange markets (access and risk reduction)
• credit for importers and funding for exporters
• international lending (both corporate and project based).
International banking exists because there is an economic benefit to be
derived for the market in general and profit for individual institutions in par-
ticular. There is the potential to gain a comparative advantage in particular
areas and participate in international direct investment opportunities that have
the potential to add more value than pure local initiatives. Diversification is a
major driving force for the expansion of the system because it allows for geo-
graphic spread and risk reduction. Finally, participation in offshore markets
allows entry into deregulated markets where the opportunity for gain is higher
as a result of lower regulatory costs.
Country
riskanalysisandinternational
credit
evaluation
Country risk analysis or assessment and international credit evaluation are
components of an emerging discipline of analysis. At this stage, however, the
process is more an art than a science and requires a skilled workforce for it to
be undertaken with certainty and accuracy. There are many sources of infor-
mation about individual countries and internal institutions. Care must be taken
because the quality of the information can vary widely according to source and
country. This variance demonstrates the need for experienced staff who can
interpret information and accuracy. Information is available from many sources,
• The effiCiency and reputation of local commercial banks are key factors for
involvement by an external entity. Local financial institutions can be a very
effective conduit to a local domestic market. They are also an excellent
source of information about local business entities by way of credit reports.
• Central banks are normally the channel for the implementation of
government monetary policy. Monetary policy determines the level of
liquidity and the interest rate environment in relation to the health of the
domestic economy. An honest and independent central bank indicates a
well-balanced economy.
• Government agencies can be approached for information about the attitudes
of the government of the day and for an extensive array of reports and
publications that give substantial information about the country and
economy. The more information that is available, the more efficient the
deCision-making, especially if the information is reliable and accurate.
Conversely, decisions will be less reliable if based on less or inaccurate
information.
• Rating agencies are usually independent of the country and thus are very
reliable. Standard &: Poor's and Moody's are examples of agencies that
publish country reports and award country credit ratings. International
financial institutions rely heavily on these credit ratings.
• Embassies and representative offices are established for several reasons
beyond diplomatic relations. The most important function outside the
maintenance of good diplomatic relations is business development.
Personnel and information are available to source further comfort and
information.
• Magazines and recognised publications are an excellent source of
information, as long as the reader is aware of the accuracy of the sources.
Country risk assessment is the process of gaining a degree of comfort about
dealing with an institution or individuals in a foreign country. By gaining the
assurance or comfort, lenders can reduce default probabilities to acceptable
levels, albeit potentially higher than those of domestic transactions but in line
with profit and projections. Problems will arise, but careful analysis lowers the
potential of a catastrophic incident having an impact on the statement of financial
position of the financial institution. The main problems areas are legal issues,
time, communication, country insolvency, potential government interference and
distance. If these problems are addressed in the analysiS stage and not the
workout stage, then international operations can be a valued addition to any port-
folio. If offshore operations are assessed and managed in line with domestic
facilities, however, then disaster will surely strike. Further levels of analysis are
314 Part4: Corporate

andbusinesslending I
needed; unique features impact on the international lending proposal and care
needs to be taken in evaluation. A suggested overlay method of analysis is called
the step-down approach (Fraser 1989). This approach allows for a staged ana-
lytical examination of an overseas party with a decision process that allows for
exit if barriers before the client become evident.
The process consists of analysis of the following components in order of time
allocation and merit:
1. The geography and demographics of the country are examined to ensure
compatibility and acceptability from the lender's viewpoint.
2. Is the overseas government acceptable to our own authorities? Are there any
embargoes that make trade unacceptable or even illegal? What is the govern-
ment's credit standing? What are its levels of reserves? How does it manage
the fiscal aspects of its own economy, as distinct from monetary policy?
3. Is the country's central bank independent? How well does it manage the
monetary policy? This is a crucial question because the central bank may be
the party that approves the transfer of funds.
4. A commercial bank of the foreign country will form the basis of the ongoing
relationship and will perform the duties of agent on behalf of the home
bank. The home institution needs to know the other bank's viability and
how it honours its commitments.
S. Finally, how strong are the corporate and other institutions in the foreign
country? What is the reputation and standing of the overseas corporate
sector? A healthy report here indicates the health and vibrancy of the
foreign economy.
This step-down method allows for decisions to be made at the macro level,
where information is most available and reliable. Using the step-down approach
means time and energy are not expended on a client when our own government
has placed trade embargoes on the country, for example. In other words, no
matter how good the client, if the other factors do not pass appraisal, then there
is no deal.
Tradefinance
There is really no difference between the techniques of financing imports and
exports because the principles are similar; the process is simply applied from
the opposite point of view.
The banking and financial system plays the pivotal role in the settlement
arrangements for most import and export transactions. In many instances,
banks and other financial institutions are requested to provide finance pending
the receipt of cash from either final sale of the goods or their manufacture into
finished products.
A large volume of overseas trade is covered by short-term finance (up to 180
days). A majority of the flow of international trade is set at or below this term,
but some discussion on medium-term and long-term trade finance is included
in this chapter. To the recipient, trade finance is simply working capital; it allows
a company, firm or individual to carryon its day-to-day operations. The meaning
of the word 'finance' in this context is the granting of credit to a buyer and/or
the provision of cash to a seller. Overdrafts, loans, negotiations, specialised
advances, trade credit, factoring, leasing, hire purchase, forfaiting and dis-
counting are all associated with resolving the problem of the timing of settlement
between receipt of the goods and the ultimate receipt of cash following their sale
to the ultimate buyer. An importer may wish to defer payment to assist its cash-
flow, whereas an exporter wants the cash as soon as possible. Finance usually
relates to a lending technique often provided by banks or financial institutions
to bridge this settlement timing problem of trading partners.
The security aspects required to extend finance for international trade
include those applicable to other lending arrangements. The customer's integ-
rity, trade experience and past record, and the length of time for which the
funds are required are important supplementary factors.
The importer has to keep in mind that the total cost of the goods will be influ-
enced by the method of finance and terms of payment involved. If the seller pro-
vides finance terms to the buyer, then interest expenses will be included in costing
the product to the buyer. In turn, the importer is required to meet the cost of
any further arrangements for finance (Tant &: Vincent 1991).
Methods
ofpayment
andfinancing
techniques
The methods to be used in the payment for imports and exports are reached by
agreement between the exporter and the importer, and must account for the
terms in the underlying commercial contract. The relative bargaining strengths
of each party to the transaction affect the final outcome.
The most important factors influencing the attitudes of the two parties
include the following:
• the safety of the transaction (with regard to credit, exchange and transfer
risks) from the exporter's point of view
• whether the exporter is prepared to extend credit to the importer, provided
the former's financial resources are adequate to carry the extended finance.
For this purpose, the exporter will require sufficient working capital or the
ability to obtain financial assistance from a bank or other sources. Finance
provided in this manner is known as post-shipment finance.
• the importer's views, which are likely to be influenced by competitor
suppliers' terms, trade practice and the cost in terms of interest (if
applicable) and bank charges. Where interest rates are lower in the importer's
country, the importer may prefer to obtain finance domestically and
endeavour to obtain trade discounts for paying cash to the exporter.
Accordingly, an exporter must be able to analyse any proposed method of
payment to ascertain how these factors apply and what advantages may result.
At the extremes, an exporter can request payment before the goods are shipped
(pre-payment) or forward goods on an open account basis. In the latter case,
the importer obtains control of the goods and possibly receives the proceeds
from selling them before being required to pay the exporter. There is virtually

no risk in selling on the basis of pre-payment. If goods are sold on an open
account basis, however, the exporter depends on the integrity and financial
standing of the buyer.
The method of payment for the above two options would be a clean transfer,
particularly a telegraphic transfer through the banking system. The predomi-
nant method of effecting payment, however, is a bill of exchange, or draft.
Pre-payment
Pre-payment means that the seller has both goods and money, and implies that
the following factors are present:
• absolute trust by the buyer that the seller will deliver the goods that the
buyer has ordered
• confidence by the buyer that the government of the seller's country will not
prohibit the export of the goods after payment
• knowledge by both the buyer and the seller that exchange controls (if
applicable) in the buyer's country will permit advance payments
• knowledge by the seller that the buyer has sufficient liqUidity in the statement
of financial position or can obtain working capital by way of import finance.
Unless the supplier is in a strong bargaining position, there are special circum-
stances (such as dealings between affiliated companies) or the goods are urgently
required, pre-payment is not usual. Advance payments are more usual for small
items such as imported books and subscriptions to journals. Pre-payments can
be used, however, as part payment or deposit for capital equipment such as
trucks and plant for mines.
To pre-pay for goods, an importer must have sufficient resources to finance
the transaction.
Documentary
exportbillsforcollection
An exporter can lodge a draft drawn on the buyer, accompanied by related ship-
ping documents, to a banker for forwarding to a correspondent bank in the
importer's country, to be released against payment (or acceptance of the draft if
terms are being provided). Payment is not made to the exporter until the draft
has been honoured and the exporter's bank receives the proceeds. The exporter
usually draws the draft on the importer at sight and directs the correspondent
bank that the documents of title are not to be released to the buyer until pay-
ment of the draft. Control of the goods is thereby retained by the exporter
(through the medium of the bank) until settlement.
An exporter may, however, be prepared to extend credit to the buyer by drawing
a term draft on the buyer (importer) and authorising the bank to surrender the
documents against acceptance only of the draft. Under this arrangement, title to
the goods passes to the buyer before payment is made and the exporter's financial
resources must be sufficient to provide the terms to the buyer, who is effectively
now represented as a debtor to the exporter. For this reason, export does not
often occur on the basis of 'documents against acceptance', although it is rela-
tively common for some international companies to use this method when
shipping to their own branches or subsidiaries overseas.
Under a collection basis, the exporter is providing the importer with post-
shipment finance, at least until a sight drawing is paid and proceeds are returned.
If a term drawing is involved, then this post-shipment finance is extended to the
period covered by the draft. This suggests that the exporter has the liquidity to
provide the importer with trade credit or has access to finance by way of an over-
draft, a bill line, an offshore loan or a currency trade finance facility.
Pre-shipment
financefacility
In some instances, the exporter's position may be liquid enough for the finance
to be provided from working capital or other resources. Exporters often look to
their bank for finance for at least the pre-shipment period. Finance is generally
provided via (1) an overdraft or a special pre-shipment finance facility, or (2) a
foreign currency advance.
Understandably, the exporter generally seeks the least expensive method of
trade finance. The level of interest rates domestically and offshore are therefore
important considerations. Offshore rates of interest may make a foreign cur-
rency advance a more attractive proposition to the exporter than domestic bor-
rowing. The exporter must take into account, however, the exchange control
requirements imposed by the exporter's government and also the possible
foreign exchange risk element. In this area, we must learn from past events.
Banks and financiers extend lines of foreign currency to exporters by raising
funds offshore in their own name and then passing them on to the exporter for
a margin.
Draw-downs are undertaken at the request of the exporter, who must provide
documentary evidence of the transaction before payment (for example, a com-
mercial contract, a bill of lading or invoices).
If the foreign exchange exposure is eliminated by the use of a forward
exchange contract, then it is important to consider whether the bank's forward
buying margin is a premium (benefit) or discount (cost) to the exporter. In
assessing the benefit or cost of the forward margin to the exporter, it should be
remembered that in a foreign currency advance the exporter's exchange risk
finishes when the bank converts the funds to the domestic currency, provided
the buyer subsequently pays for the exported goods. Given that the bank uses
the proceeds of the export item for payment of its overseas borrowing, nonpay-
ment by the buyer would require the exporter, in settlement of the foreign cur-
rency advance, to purchase the foreign currency at the bank's then current
selling rate of exchange. Thus, failure of the buyer to adhere to the commercial
contract could result in a loss to the exporter.
Post-shipment
financefacility
This faCility allows documentary export bills not negotiated under a letter of
credit to be turned into a financing instrument, to facilitate pre-shipment finance.
When an exporter decides to ship goods without establishing a documentary
letter of credit in its favour by the overseas buyer'S bank, but wishes to obtain
immediate value for the goods at time of shipment, the bank may agree to 'nego-
tiate' a draft on the buyer, which must be accompanied by the documents of title

(including all negotiable copies of the bill of lading). By negotiating, the bank in
effect purchases the bill of exchange while retaining recourse on the drawer until
the drawee (the importer) pays the bill. Before negotiating a documentary bill,
the bank must consider the integrity and financial standing of the exporter and
the overseas buyer, and may need to weigh other factors such as the political and
economic conditions in the country of destination, the possible effect of any
exchange controls operating there, the type of commodity and the overseas
demand for it. The bank will also require that the documents allow it to obtain
full title to the goods and that the draft and documents are correctly endorsed,
as may be necessary before despatch overseas.
Bills are generally negotiated on a 'documents against payment' basis; that is,
the documents of title, when forwarded by a bank to its branch or agent bank
overseas, are not released to the buyer until the latter has paid the related draft.
If the customer seeks to export on a 'documents against acceptance' basis, then
special consideration will need to be given to negotiation, because a bank will
lose control of the goods before payment and thereby forgo the support of the
goods as security if the overseas buyer does not honour payment of the draft
when due.
When documentary bills are presented for negotiation, the bills and relative
documents are examined closely before their despatch overseas, to ensure they
are required and do not contain any irregularities or objectionable features that
could render them unacceptable to the buyer or prejudice payment. The out-
come of negotiations under 'documents against payment' or 'documents against
acceptance' is that a financier records a contingent liability against the name of
the exporter until the importer pays the draft.
Documentary
bill of exchange
This facility involves releasing documents to the buyer either after physical pay-
ment of the instrument or against acceptance of the bill of exchange for a specified
term. Under these arrangements, the supplier (exporter) draws a bill of exchange
on the buyer, (importer) and forwards it and the relative documents to a bank
in the importer's country, either directly or through its own representation.
The bill is presented to the buyer and, provided payment or acceptance (as
appropriate) is forthcoming, the importer's bank will release the documents in
accordance with the accompanying instructions received from the overseas
supplier or bank.
Payment in this way involves the supplier extending credit to the buyer for a
period of time, with the length of time being determined by the tenor of the bill
(the sight or term) and whether the instructions forwarded to the bank in the
importer's country permit payment/acceptance to be deferred until arrival of the
goods.
Where the importer arranges to pay on a Sight basis, it may need to arrange
finance locally to cover the period from the date of payment to the exporter
until payment is received from the end buyer of the goods. This finance may be
/' -
provided by the importer internally (from its own resources) or from a domestic
bank, depending on the construction of its cashflow.
If the importer has an option of either paying at sight (using finance from
one or more of the above sources) or accepting the supplier's offer of terms, it
should compare the supplier's sight and term prices with the cost of domesti-
cally sourcing finance. Further considerations are the cost or benefit of entering
into a forward exchange contract.
As with the other methods of payment, it is also important that the buyer and
seller understand who is responsible for all charges.
Foreigncurrency
tradefinancefacility
A financial institution provides this facility where it uses its foreign currency
holdings to finance (for less than 180 days) an importer that has a shortage of
cash. It is useful to an importer when:
• the supplier is drawing on a Sight basis or an after-sight basis, where interest
charges are for the importer's account
• importers/exporters request finance for their open account trading
• documents are not handled by a bank or financial institution.
Documentary
lettersofcredit
The conflicting problems in a trading transaction, particularly international
trade, are that:
• the buyer is anxious to receive the ordered goods in good condition and
before a stipulated date, and would prefer not to pay until they are received
• the seller wants to ensure that the buyer will pay for the goods and,
particularly in the case of an international transaction, that payment will be
received before control of the goods is lost. The exporter may want an
assurance of payment before the goods are produced.
The conflict of interest between exporter and importer calls for a compromise
in the form of payment against documents representing the goods. From the
point of view of both parties, the documentary letter of credit (documentary
credit) is a satisfactory way of achieving this compromise.
A documentary credit may be described as a set of instructions provided
by a buyer to its bank (the establishing bank) with the request that they be
transmitted to the seller (the beneficiary) or the seller's bankers (the
advising bank) for delivery to the seller. These instructions must state
clearly the amount of the credit, the goods required, the required documents
to be presented by the exporter when seeking payment for the goods, and
the expiry date of the credit. The credit usually calls for drafts to be drawn
by the shipper, either on the advising bank or the establishing bank (or its
agent), or on the buyer. In transmitting the instructions, the establishing
bank engages to honour all demands made in terms of the credit. When the
goods are ready for shipment, the beneficiary of the documentary credit (the
exporter) presents the required documents stipulated in the documentary
credit - accompanied by a sight or term draft (unless not called for) - to
the negotiating bank (which may not necessarily be the advising bank).
320 Part4: Corporateand businesslending I

Provided the documents are exactly as called for, other terms and conditions
of the credit have been complied with and the resources of the establishing
bank are sufficient to cover the transaction, the exporter will receive pay-
ment.
The exporter is thus able to obtain immediate payment without the liability
of recourse attached to the negotiation of a bill of exchange. The exporter is
nevertheless liable to the buyer if the goods supplied are not in accordance with
the commercial contract, notwithstanding that the description of the goods in
the related documents complies with the description provided in the docu-
mentary credit. The negotiating bank assumes no liability, provided it has taken
delivery of documents conforming in all details to the stated requirements of
the documentary credit.
Note, however, that financial institutions and banks deal only in documents
and not in the actual goods being forwarded by the exporter to the importer.
Most documentary letters of credit are irrevocable and, provided the exporter
complies with all terms and conditions of the documentary credit (including
documentation), the bank must make payment. Payment depends on the
resources of the establishing bank being sufficient to cover the transaction.
Export documentary letters of credit may be directed to the advising bank by
cable or mail, or by agent banks that maintain formal arrangements to establish
letters of credit.
Every negotiation of a drawing under an export credit represents a temporary
advance by the negotiating bank, and reimbursement by the establishing bank
is conditional upon full compliance with all terms and conditions of the credit.
The negotiating bank must exercise the utmost care to ensure documents
against which it makes payments are correctly issued and comply fully with the
documentary credit; that is, all documentary credits are governed by the 'rule of
strict compliance'.
The following types of documentary credits may assist an exporter in
obtaining pre-shipment finance.
Red clause credits
These credits incorporate a clause that authorises the advising bank to make an
immediate payment to the benefiCiary of an amount up to the total of the credit
(or some lesser amount). The red clause facility may stipulate that the advance
is to be made against production of specified documents (for example, storage
warrants or an insurance cover note), but more often is not subject to any
special conditions.
The red clause faCility authorises the beneficiary to draw up to the amount
specified before prodUCing the relative export shipping documents. It enables
the benefiCiary to obtain an overdraft from the advising bank (guaranteed by
the buyer's bank) and to repay the loan with the proceeds of the drawing(s)
made in tenns of the documentary credit. The facility is generally restricted to
exporters whose integrity is considered unquestionable by the overseas buyer,
or to affiliate or subSidiary firms.
Head and counter credits (also known as back-to-back credits)
There are occasions when an exporter buys goods from one party and sells
them to another, with both sides of the transaction financed by means of docu-
mentary letters of credit. If the bank that issued the buying credit has done so
on the strength of the selling credit, then these credits are termed
head-and-counter credits, or back-to-back credits.
The exporter substitutes its own invoices for those of the supplier (whose
invoices would normally show a lesser amount) and meets the drawing under
the local credit from proceeds of the drawing under the overseas credit in its
favour. Operational problems and security aspects require careful attention in
this procedure.
Transferable documentary credits
This form of documentary credit may be transferred to another party by the
beneficiary. The beneficiary has the right to instruct the bank called on to effect
payment (or acceptance) or any bank entitled to undertake negotiation to make
the credit available in whole or in part to one or more third parties (second ben-
eficiaries). A transferable credit provides another means by which an exporter
can pay the initial supplier of goods to be exported by a documentary credit.
Exporters considering this procedure should liaise with a bank or financier
before any commitment is made.
A charge may apply for the transfer of the documentary credit. This can be
claimed from the prime (first) beneficiary.
It is clear that international trade is a two-edged affair. Our discussion has
largely revolved around the impact on an exporter; now we will look at the
same issues from an importer's point of view. The point of time at which the
importer is required to pay the bank generally depends on the mechanics of the
credit, particularly the method of reimbursement to the overseas paying/negoti-
ating bank. It could be as early as when the bank receives a telegraphic advice
from the paying/negotiating bank or at a later date, after the draWing arrives in
the importer's country by airmail. Either way, the importer usually pays funds to
meet the drawing under the documentary credit before gaining the physical
goods to sell them and receive payment.
The importer is thus left to finance the transaction for the intervening period.
If the importer is able to finance the transaction internally from its own funds,
then it must consider the opportunity cost of how profitably the funds could
have been used for a different purpose. If the importer needs to borrow, then it
will need to pay interest. The following additional charges are also involved and
should be included in any costing considerations:
• bank charges for issuing the credit
• ,interest payable when foreign currency drawings are involved, for the period
by which the provision of the currency by a bank precedes the date of
payment by the importer
• payment and/or negotiation commission charged by the overseas bank(s).

Documentary
creditsproviding
fortermdrawings
Documentary credits that provide for term drawings can be used to cover the
payment for the goods in a foreign currency where:
• the supplier is willing to accept a letter of credit providing for term (sixty
days sight, for example) drawings but wishes to receive payment on a sight
basis without the cost for the term involved
• the supplier has quoted a price for selling to the importer on terms (thirty
days, for example).
Neither procedure requires the importer to pay domestically until the
maturity date of the drawing. In essence, the importer has obtained a foreign
currency finance facility for the relative term. This could be an advantage when
the interest (discount) rate (plus overseas bank charges) in the overseas centre
for the currency concerned is less costly than domestic financing.
Charges to be considered by the importer in its costing considerations
include:
• the charge by the domestic bank for issuing the credit
• acceptance and discount charges by the drawee of the term draft
• the supplier's increase in the price in line with bank discount charges.
Documentary credits may also be issued in the domestic currency. The discount
rate on a domestic currency term drawing would reflect domestic interest rates.
Cleanremittance
afterthebuyerreceivesorsellsthegoods
A clean remittance of this nature would apply to payment for goods at a speci-
fied time after receipt by the buyer (open account trading) or as and when the
goods are sold (that is, when goods are shipped on a consignment basis).
The exporter provides the finance from its own resources, but a bank would
be indirectly involved if, say, the exporter used an overdraft to finance the ship-
ment. Bank charges for this method are interest (if a bank overdraft is
involved), a handling commission (if documents are forwarded through the
bank) and overseas bank charges in certain circumstances.
Tradefinance- medium-term
tolong-term
The types of trade finance discussed so far are of a short-term nature. Longer
term finance for exporters is also available from private enterprise and govern-
ment financiers. The most important government agency in terms of providing
assurance of payment to exporters encompasses the insurance of payment terms
from importers (buyers) of goods in other countries. To encourage the export of
capital goods and services, a further facility known as 'buyer credit' is generally
available to exporters where terms mainly exceed five years. Banks participate
in this process but the facility is normally guaranteed by a government agency.
The facility is designed to supplement the existing facilities provided by finan-
cial institutions and is available under strict conditions.
Given the amounts involved, many importers purchasing capital goods from
overseas suppliers often need medium-term or long-term finance (five years and
beyond) such as forfaiting (see page 324).
Funds can usually be obtained either in the domestic currency, whereby a
bank's domestic deposit base enables it to reliquify itself through the
short-term money market or bank bill market. Financial institutions can also
obtain funds offshore in various markets. The euro market is by far the best
known of the markets in foreign currency deposits that has developed over
the past forty years in Europe and elsewhere. It has developed into the largest
international money market. The proceeds are widely used in financing inter-
national trade and also converted into other currencies for domestic financing.
Such a market has been in existence on a substantial scale since only about
1957.
London remains the largest financial centre in the world. Singapore and Hong
Kong compete for the role of the leading Asian financial centre. There are also
markets in Paris, Brussels, Luxembourg, Frankfurt, Amsterdam, Zurich, Milan,
the Gulf States and Japan, with increasing activity in the Caribbean and
Bahamas.
Thebankers'acceptance
market
The history of this market can be traced back to the twelfth century when
forms of bills of exchange were used to finance international trade. In the eight-
eenth century, bankers' acceptances became widely used in commerce and had
a flourishing market for Sterling bills in London.
The bankers' acceptance market in the United States was founded in 1913
and is modelled on the Sterling market. The concept is similar in Australia. The
market is used to finance both importer and exporter transactions, but
minimum amounts apply. The major features of this facility are:
• access to a competitive source of finance
• the enablement of an exporter to provide terms to an importer
• the provision of access to pre-shipment finance, provided a firm contract of
sale is held
• the enablement of importers to obtain discount purchases by paying on an
at-sight basis
• the ability to swap US dollar proceeds for other major currencies, if required.
Forfaiting
Forfaiting is a form of finance provided for exporter manufacturers who are
required to provide deferred credit terms with payments spread over, say, five
years, and who wish to obtain finance for the buyer without recourse to them-
selves (that is, the exporter is paid in full immediately).
It involves the nonrecourse negotiation of a series of promissory notes or,
occasionally, avalised bills of exchange or guaranteed book debt obligations, at
an all-in fixed rate. The forfaiting bank, in making an outright purchase of the
promissory notes or bills, assumes complete responsibility for their payment at
maturity, including political and economic risks. The period of credit over
which the bank will proVide finance depends on its view of the political!
economic scene in the buyer's country.

It is normal practice to insist on receipt of the buyer's promissory notes duly
avalised by an acceptable bank. Forfaiting provides the following advantages for
the exporter:
• It unburdens the statement of financial position of the exporter from
receivables and/or a contingent liabilities position. With medium-term trade
credit extensions, contingent liabilities can involve considerable and sharply
increasing amounts.
• It improves liquidity. (This and the above advantage result in an increased
credit capacity for the exporter.)
• It helps avoid losses that can arise from the retained risk position under
government or private insurance coverage schemes, and from impediments
to liquidity during the customary period for study of the exporter's claim.
• It helps avoid the risks of higher financing costs arising from increasing
interest rates.
• It shifts the exchange rate fluctuation risks.
• It removes all administrative and collection problems and related risks.
Exporters, confronted with the increasing demand for favourable credit terms
for their sales, will find a valuable and flexible instrument in the possibilities of
forfaiting, particularly given that discount rates can be agreed in advance of
final contractual terms concluded with buyers. Forfaiting is an extremely rare
product in Australia, but it is worth knowing of its existence.
Uniform customs
andpractice
fordocumentary
credits
A great variety of commercial practices exist among the trading nations of the
world. These practices could give rise to considerable confusion in interpretation
from one country to another. To minimise confusion and to standardise as far as
possible international practice in establishing and advising documentary letters
of credit and negotiating drawings thereunder, the International Chamber of
Commerce formulated the Uniform Customs and Practice for Documentary
Credits. This code is applied by banks, financial institutions and banking associ-
ations of virtually every country and territory of the world; individual organ-
isations can subscribe as well as whole countries.
All documentary letters of credit issued usually include the clause 'Subject to
Uniform Customs and Practice for Documentary Credits (I9XX Revision), Inter-
national Chamber of Commerce. Brochure No. 4XX'. Similarly, when advising an
exporter of the establishment of a documentary letter of credit, banks include a
clause signifying that the bank concerned participates in the code.
International
lendingprinciples
In the Simplest of terms, the primary function of any bank or financial insti-
tution is to raise depOSits and lend money. These activities can be done in many
ways and in many and varied markets across the globe.
Under the pressures of daily workloads, it is easy for the professional banker
to dispute the above statement. We often think of a bank as a lender of money
only when it is granting an advance to a customer to meet a specific need (such
as to purchase property). Yet whenever a financial institution is requested to
advance funds for any reason, for which end reimbursement or payment from
another source (third party) has not immediately been provided, a financial
institution is advancing money and can be at risk of sustaining a loss. In nego-
tiating export documents, for example, a bank is providing finance to the
exporter and is exposed to the risk that the relative claim may be returned
unpaid.
The simple negotiation of a customer's foreign currency cheque is also an
advance. If, with approval, proceeds of an overseas cheque are paid to a cus-
tomer directly, then the bank has advanced the amount of the cheque until
reimbursement is obtained from the overseas institution on which the cheque
was drawn.
Personnel involved in international activities must be aware of the basic prin-
ciples that relate to advances where the financial institution cannot readily
obtain reimbursement or payment. Through a better understanding of the prin-
ciples relating to advances for international trade, international business per-
sonnel are better equipped to fully understand the transactions and appreciate
that international business is just another method by which a financial insti-
tution can raise deposits and lend money to make a profit.
There is essentially no difference between credit assessment for domestic
lending and that for offshore advances; the latter is an extension of the
basic prinCiples. Consider all the methods and techniques that have been
discussed in this and other chapters. Once you have reviewed the tech-
niques, then overlay the suggested process for country risk assessment (see
pages 313-15). This method will ensure no wasted effort is expended on
futile propositions.
Once you complete the above process, consider the three basic principles of
lending, which must be remembered when evaluating requests for the bank to
advance money for any reason: safety, suitability and profitability. These three
considerations are as valid for evaluating a trade finance proposal by an
importing/exporting client as they are for evaluating a corporate or business
loan request.
Safety
A financial institution is exposed to a financial risk on entering any transaction
that requires the advance of money for any purpose. This risk must be reduced
to an absolute minimum and the safety of the institution's funds must be
upper-most in a person's mind. Each transaction is unique and requires the pru-
dent lender to be aware of risk and to take all actions available to ensure the
loan will be repaid.
The loan officer needs to consider all the questions required for a domestic
transaction, including the following questions.

• What does the lender know of the person to whom funds are being advanced?
• What is the reputation of the borrower?
• Does the borrower possess the ability to complete the commercial transaction?
• Can the borrower service the advance?
• Is the advance within the bank's current policy guidelines?
Along with the above, the following questions must be asked for certain
international transactions:
• How will payment for the goods occur?
• When can payment be expected?
• What does the lender know of the overseas banks that may be involved?
• Are the banks in correspondence?
• Is the country economically and politically stable?
• Has the customer used this market previously?
• Is the overseas trader well-known internationally?
• Have foreign exchange fluctuation risks been minimised?
Many of these questions can be answered by the client. If not, then the infor-
mation must be gathered from various sources.
Security
While advances granted by a bank should be on a secured basis, in most cases
security is only a form of insurance for a bank if anything unforeseen occurs
(see 'the three ways out' of a loan in chapter 8). Security should be considered
as a display of confidence by the borrower in hislher ability to meet the debt
created. It is essential that security documents be completed correctly and regis-
tered, without delay. Clients tend to be more cooperative before money is
advanced than afterwards. Additionally, persons and companies granting
security must be fully aware of their commitment to the financial institution.
Financialstandingofclients
It is not easy to ascertain the real worth of a client. Financial institutions rely on
financial statements, but the loan officer will also learn to glean sustainable and
supportable information from financial records, interviews and market sources
to gain a reasonable impression of the client's personal and corporate standing.
Borrowers tend to overestimate the value of assets, so it is critical for a loan
officer to be able to analyse and assess the true value for security purposes.
Failure to judge fair value could result in large loan write-offs.
Businesses and corporates are required under law to produce accounting
documents such as statements of financial position, statements of financial
performance and cashflow statements. Such documents, however, are a sum-
mary of financial activity at a defined date and can be subject to dramatic
change in a short period. Lenders also seek cashflows or budgets detailing the
anticipated income/expenditure for the forthcoming year or budgeted period.
These figures are often only guesswork, but they provide some guide to
future expectations based on past trends. Careful ratio and trend analysis will
give a degree of comfort for the loan officer.
r _
An international loan officer needs to have a detailed knowledge of business
structures - not only locally but also internationally - in the area of their
responsibility. Entities may vary from a large listed corporate entity to a large
family company, to a small family company, to partnerships and sole traders.
Each can make formalised borrowings, but the structure and recourse of the
loan will be different. A large company, for example, may own several subsid-
iaries; each company within a group of companies is a separate legal identity
governed by its constitution. The debts of such companies may not be secured
by any documentation held over the assets of another company (parent or sub-
sidiary) within the group unless there is some interlocking security that links
the assets of each member of the group. A partnership, on the other hand,
involves both joint and several (separate) liability; that is, each partner is liable
severally for the partnership debts (unlimited) and liability extends to private
property.
Economic/political
factors
The risks involved in advances for foreign activities are greater than those
associated with domestic lending. Sudden changes of official government
foreign policy or changes in a country's economy can greatly affect an insti-
tution's exposure. It is difficult to realise security held over goods or assets that
are located in a foreign country.
Political situations can change overnight in any country and can seriously
affect the ability of that country or an overseas bank to make payments. Many
countries are stable at this time, such as the United States, the United Kingdom
and Singapore, but transactions with less wealthy or politically unstable coun-
tries carry greater risks. A lender must consider these risks when assessing the
merits of granting an advance.
There is a trend to lessen normal approval criteria to secure new business
against active competition, both local and international. These proposals must
be thoroughly vetted, with an emphasis on the borrower's management exper-
tise and past record.
Ongoing
riskassessment
Risk assessment is ongoing and should not be undertaken only when the
advance proposal is being considered. Assessment of the degree of risk and its
acceptability (or otherwise) must be an ongoing part of the loan review process.
During a review, a lender must examine:
• the continuing viability of the debtor
• the relationship of the advance to the security valuation
• the security, to ensure it remains enforceable
• the ownership of assets of any company borrower, to ensure they are not
beyond the scope of the institution's security
• the effect of any additional outside liabilities of the borrower.
Loan officers need to be careful that the degree of risk remains within accept-
able bounds because the circumstances of the borrower and the financial insti-
tution's security may change over time.

Suitability
While loan officers must remain flexible in meeting customer needs, remember
that a financial institution is not only able to dictate terms suitable to itself -
it must do so! Loan officers must adhere to the executive's directives, as set out
in the current advance policy. The purpose of the loan must align with current
expectations for the construction of the loan portfolio. A financial institution
would not wish to become involved in, for example, the financing of illegal or
immoral activities or those of a purely speculative nature. Other aspects
relating to the sUitability of an advance include a reasonable contribution by
the borrower (hurt money - see page 244) and the terms of repayment.
Profita
biIity
A financial institution, like any business, is in the marketplace to make a profit
for its shareholders. Obtaining deposits from customers or markets for a
minimum cost and lending these funds to other clients at the highest acceptable
price will achieve this profit.
Banks tend to charge less than other lending institutions, resulting at times in
an excessive demand for bank finance. Banks are therefore selective and conser-
vative in approving requests for finance. They should exhibit a lower risk pro-
file than that of other institutions.
Two main factors contribute (either directly or indirectly) to the profitability
of any lending proposals:
1. collateral advantages - the gainlloss of additional business from granting!
declining any loan facility
2. return on funds - the profit margin between the cost of obtaining deposits
and the income received from advances.
liabilities
The bank's assets are the clients' liabilities. Liabilities fall into the following two
categories:
1. direct liability, which normally arises where two parties are involved (the
debtor and the creditor). Examples of direct liabilities are overdrafts and
loans, leasing, surrendered bills of lading, commercial bills and standby
letters of credit.
2. contingent liability, which generally involves more than two parties. A bank's
risk of nonpayment is secondary or subsequent to a primary obligation. In
other words, a debt exists between the bank and the customer only in the
event of another party taking certain actions; if the liability is acted upon,
then the liability becomes direct. Examples of contingent liabilities are docu-
mentary letters of credit, forward exchange and foreign currency contracts,
and bills negotiated for exporting customers.
An international loan officer must have some understanding of commercial
contracts and the implications of entering into contracts. In basic terms, for
there to be a contract, two or more parties must possess a common intention
and there must be a communication of this intention - known as offer and
acceptance. Until an offer is accepted, there is no contract and the offer may be
withdrawn. After acceptance, there is a contract, which is binding on all parties
and unable to be revoked by anyone party Offer, acceptance or both may be
written, oral or by conduct.
Bankguarantees
Commercial contracts sometimes require the support of a bank guarantee. An
example is a letter of credit. During the course of normal business, a bank may
be requested to provide overseas parties with a guarantee in support of a cus-
tomer's obligation to fulfil a contractual commitment.
An overseas party may require assurance that a potential new client has the
technical and financial competence to undertake any contract awarded and that
the contract, if attained, would be fulfilled to the maximum. This form of
guarantee is known as a bid or tender bond.
In such cases, the financial institution establishes the bond. In the event of
default by the supplier, the overseas buyer may call up the bond (that is,
demand payment). Depending on the terms of the bond, the financial insti-
tution may be obliged to pay on first demand, even if such a demand seems
unjustified. It is the norm for a financial institution to take an indemnity from
the bidder to cover any such demands. The indemnity enables a reimbursement
from the bidder to be claimed if the need arises.
Similarly, after a contract has been awarded, a foreign buyer may seek assur-
ances from a bank that the contract will be satisfactorily fulfilled; this is known
as a performance bond or guarantee. A similar situation arises when a bank is
requested to endorse a bill of lading guarantee, which occurs when a bill of
lading has been stolen or has not yet been received. The importer writes to the
shipping company, indemnifying them against any consequences for delivering
the goods without production of the bill of lading. In endorsing such a
guarantee, a bank assumes the same liabilities as those of the shipping com-
as does the importer. The taking of an indemnity from a customer in each
of these situations is no different from taking formal security; it simply estab-
lishes a second way out of the advance. In other words, in the event of another
party claiming payment from the bank, the bank will seek reimbursement from
its client.
We have looked at the development of the modern international financial
system and how it forms an important source of liqUidity for our local insti-
tutions. It allows for diversification of the loan portfolio in both assets and
funding sources. Even small players are able, via the local financial system, to
access the benefits of a much larger and diversified market. We haw also
examined several products that are available for the international lending
officer and how they can enhance the value of the financial institution. Inter-
national credit analysis, as discussed in other chapters on domestic finance, is

overlaid with the need to ensure the safety, security and profitability of the
loan so there is a degree of assurance of security and payback. It is necessary
to understand that an extra layer of credit analysis is needed, however,
because the financial institution is exposed to more risks when it is involved
in the international arena.
Summary
1. What is the structure of the international financial marketplace?
The modern international financial system commenced in the early 1950s as
an outcome of the Bretton Woods agreement of 1944 and continues to
evolve. The euro markets have emerged as the strongest component of the
system, because the pricing differentials allow for gains for both borrowers
and lenders. The international markets consist of several components, from
foreign exchange to equities.
2. What are the main principles of international lending?
The principles of international lending (safety, suitability and profit-
ability) add to the normal principles of borrowing as discussed in other
chapters.
3. Why are trade finance products so important in the international finance
arena?
International trade forms the major physical component of the international
financial markets. The system allows for pre- and post-shipment finance and
facilitates the physical movement of goods and the ongoing financing of
services.
4. Why are international operations important to financial institutions?
Involvement in the international financial markets allows a financial
institution to grow markets outside its core location. It also facilitates
diversification of funding sources and generates opportunities in crowded
markets.
5. What is suggested as the most efficient process of country risk analysis?
The step-down approach is the most efficient critical analysis of risk, looking
at the country, its government, its central bank, its commercial banks and its
corporate sector in that order.
bank guarantee, p. 330 international credit safety, p. 326

country risk analysis, evaluation, p. 313 step-down approach,
p. 312 international financial p.315
interbank market, p. 312 system, p. 312 suitability, p. 326
intermediation, p. 312 profitability, p. 326 trade finance, p. 312
rating agencies, p. 314
uestions
1. A company sells goods to Meghan Enterprises on 'open account' terms.
Explain the methods by which the importers can pay and compare
them from the exporter's viewpoint.
2. What is country risk analysis?
3. A suggested method of credit evaluation is the step-down approach, or
the evaluation of institutions in a country in descending order of impor-
tance. What are the major points to be considered in this method?
4. What are the principles of international lending?
5. Explain the differences between the following instruments:
Ca) Irrevocable letter of credit
(b) Back-to-back credit
Cc) Red clause credit
Cd) Open account.
6. How can the risk of international problem loans be reduced?
7. What are the benefits to a financial institution of involvement with
clients using bank guarantees?
8. How can a loan officer protect the financial institution against fraudu-
lent activities?
9. What distinguishes the majority of trade finance facilities from other
lending facilities?
10. Why, if at all, is international lending different from the domestic oper-
ations of a financial institution? In your discussion, consider the risk
and return.
References
andfurtherreading
Fraser, R. D. 1989, International Banking and Finance, R & H Publishers.
Eiteman, D. K., Stonehill, A. I. & Moffett, M. H. 1998, Multinational Business Finance,
8th edn, Addison Wesley, Reading, Massachusetts.
Shapiro, A. C. 1992, Multinational Financial Management, 4th edn, Allyn & Bacon,
Boston.
Tant, K. T. & Vincent, M. J. M. 1991, International Trade Finance.
I 332 Part 4: Corporate

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Creditriskmeasurementand
management of theloan
portfolio
Learningobjectives
After readingthis chapter,you shouldbe ableto:
1. describethe benefitsof creditrisk management
2. explainand useAltman'sZ score
3. explainhow stockpricescanbe usedto explain

credit risk
4. suggesthowrisk-adjustedreturnoncapitalcanbe
usedfor portfoliopurposes
5. usethe SharpeIndexfor lendingpurposes
6. calculatethe risk of a loanportfoliousing

\1
7 understandthe elementsof loan

Introduction
Not long ago, lending institutions did not have departments that took an insti-
tutional perspective of the lending portfolio. Loans were granted and were
promptly forgotten as long as borrowers made their scheduled repayments.
These practices, however, led to loan portfolios that were not close to the
efficient frontier. The efficient frontier is a finance concept. In brief, it maps the
return that an investor should receive for a given level of risk. In terms of
lending, it means receiving an appropriate return for a given level of lending or
credit risk. The aim of credit risk management is to balance between risk and
return to achieve optimum profitability and efficiency. Bank managements real-
ised that they were not doing this.
Exacerbating this situation was the rise of relationship banking. This form of
banking was based on a manager developing close links with an entity or indi-
vidual. Often, lenders would lend too much to one entity relative to the rest of
the lending portfolio. This is known as concentration risk. The underlying
risks may be sound, but there is a danger when the economy undergoes tur-
moil. Any bank that was overly exposed to the airline industry in September
2001 might have had problems due to the downturn in the airline and ancillary
industries. Not all would agree that concentration risk is a bad thing. Some
have pOinted out that small financial institutions that focus their business
choose to wear concentration risk because they have particular expertise. Many
regional building societies, for example, have concentration risk in terms of
their credit type and geography.
Lenders recognised that lending needed to be conducted on a more scientific
basis, rather than relying on the lender-borrower relationship. This change
would remove the subjective nature of lending. Further, rather than managing
loans on an individual basis, lenders needed to manage loans on a portfolio
basis, just like any other investment portfolio, such as bonds or equity
Finally, banks questioned what happened when there were identified loans
that were not appropriate to the statement of financial position. This question
has given rise to the new credit management techniques of securitisation and
credit derivatives. Credit risk management helps a bank to achieve the following
objectives: (a) achieve an appropriate balance between risk and return, (b) avoid
concentration risk, (c) manage loans on a portfolio basis and (d) take a group
of loans off the statement of financial position.
Before credit risk can be managed, it is important to know the extent to
which the financial institution is exposed to it. This knowledge is achieved by
measuring credit risk. In the next section, we will discuss the various tech-
niques of the measurement of credit risk.
Creditriskmeasurement
Measurement of credit risk refers to the quantification of credit risk exposure of
a bank. It has a number of useful benefits, such as:
• removing the subjectivity from credit assessment
• adding a scientific basis to the credit assessment process
I 336 Part5: Assessmentandmanagementof risk I

• rating loans that have no credit ratings or providing a system of grading
• providing a mechanism for monitoring loans to ensure they are not potential
problem loans.
Many credit risk measurement models are available today. Many have been
internally developed by lending institutions, while some are available as
'off-the-shelf' solutions to lending institutions. Lending institutions often use
an 'off-the-shelf' solution as a check against an internal model. While there is a
plethora of models, most are based on either accounting ratios or information
contained in share prices. The basis of both approaches is that there are factors
that distinguish between populations of good and bad borrowers.
In this chapter, we will examine two models that use these approaches. The
Altman Z score was one of the earliest models used by banks in an attempt to
remove the subjectivity from the lending decision. It examines the accounting
ratios of two populations - failed and nonfailed companies - to assess credit risk.
A more recent development has been the use of information implied in share
prices and option pricing theory to predict default. This approach has been
popularised by KMV Corporation.
Altman'sZ score
Altman's (1993) work was predicated by work by Beaver (1967), who found
that firm bankruptcy could be predicted by the use of financial ratios for up to
five years before bankruptcy. Beaver used univariate models that distinguished
between failed and nonfailed firms for periods of up to five years in advance.
This mathematical method was derived from the biological sciences, which
define populations with different characteristics.
Table 11.1 below shows a strong relationship between credit ratings and key
financial ratios. The differences between the ratios of AAA-rated organisations
and B-rated organisations are quite marked.
TABLE 11.1 Relationship between ratings and financial ratios
Adjusted
keyindustrialfinancialratios- Creditrating
USIndustriallong-termdebt
Three-year(1998-2000)medians AAA AA A BBB BB B CCC
EBlT interest coverage (x) 21.4 10.1 6.1 3,7 2.1 0.8 0.1
EBITDA interest coverage (x) 26.5 12.9 9.1 5.8 3.4 1.8 1.3
Free operating cashflow/total debt COlo) 84.2 25.2 15.0 8.5 2.6 (3.2) (12.9)
Funds from operations/total debt (%) 2S.S 55.4 43.2 30.S 18.8 7.8 1.6
Return on capital (%) 34.9 21.7 19.4 13.6 11.6 6.6 1.0
Operating income/sales (%) 270 22.1 18.6 15.4 15.9 11.9 11.9
Long-term debt/capital (%) 13.3 28.2 33.9 42.5 57.2 69.7 68.8
Total debt/capitalisation 22.9 37.7 42.5 48.2 62.6 74.6 87.7
(including short-term debt) (%)
Companies (no.) 8 29 136 218 273 281 22
><= a time, number (thai is. a number to multiply by)
EBIT earnings before interest ancltax: EBlTDA earnings hefore interest. tax, depreciation ane!amortisation.
Source: © Standard & Poor's, a Division of The McGraw-HiliCompanies, Inc. Reproduced with permission of
Standard & Poor's www.standardandpoors.com.
To some extent, the use of accounting ratios in such analysis is a logical
extension of original credit analysis where a person would be the mechanism of
analYSiS,generating and using the ratios. Altman and others extended the work
of Beaver to improve the predicative power of such models to predict default
and/or bankruptcy. The analysis was improved by extending single univariate
models to multivariate models that used a number of financial ratios.
A survey of the research over the past thirty years has sought to identify
which accounting ratios provide the best predicative power, including:
• activity • profitability
• liqUidity • earnings variability
• solvency • size.
Depending on the industry generally, each of the above ratios has strong
predicative power. As a general rule, however, liquidity, profitability and earn-
ings variability have strong predicative power. This is easy to explain. Cash
repays loans, so those ratios with a strong cash component are the ones that
indicate the potential for debt defaults.
In the remaining part of this section, we will concentrate on the development
of the Altman Z score as a basis for considering later developments.
The Altman Z score is given as:
Z = 1.2X 1 + 1.4X 2 + 3.3X3 + O.6X4+ O.999Xs
where
Xl = the working capital divided by total assets
X2 = the retained earnings divided by total assets
X3 = the earnings before interest and taxes divided by total assets
The first four variables are expressed as decimals while the fifth is expressed as
a times number (for example, 5 x) as opposed to a percentage or decimals. We will
explain the interpretation of the result of this score later, because first it is instruc-
tive to understand why these particular variables were chosen.
Altman's initial work showed that many ratios were reasonable indicators of
the potential for default. They were further categorised into the categories of
activity, liquidity, solvency, profitability, earnings variability and size. Altman
chose, however, to concentrate on those ratios that were well accepted in the
academic literature. He reduced the number of variables to twenty-two and
used the following method:
1. Altman observed each statistical significance of various alternative functions,
including determining the relevant contributions of each independent variable.
2. He evaluated the intercorrelation among the relevant variables.
3. He then observed of the predicative accuracy of the various profiles.
4. He used his own judgement when finalising the function.
It needs to be recognised that the resulting function, as stated above, pro-
vides a good discriminant between failed and nonfailed companies but is not

necessarily optimal. The categorisation of these ratios (from page 338) then
becomes as shown in table 11.2.
TABLE 11.2 Ratio categorisation
Variable Category
Liquidity
Profitability
Profitability/productivity
Leverage/solvency
Activity
The following issues should be considered in the use of this technique:

1. It is heavily biased towards US data, so an examination of Australian data
may create a different Z score.
2. The function implies a heavy bias towards financial ratios that indicate the
firm's ability to create cashflow. This is obviously satisfying given that cash-
flow repays debt.
3. There are obvious problems with the use of financial ratios:
(a) They are open to manipulation by firms.
(b) They are also open to interpretation by analysts.
4. The function is independent of loan amount, which alerts us to the need for
supplementary analysis of the statistical method.
It is also instructive to picture graphically (figure ILl) the results of the dis-
criminant function, with the objective of having the groups as different as possible.
II)
...
E
-...
o
Q)
.c
Area of ignorance
E
:::I
Z
Bankrupt Nonbankrupt
firms firms
Z score
FIGURE 11.1 Multidiscriminant distributions using Z scores
The bounds of the two distributions are 1.81 and 2.99. A firm that scores
2.99 or above, therefore, would be considered to be to be creditworthy, while
one below 1.81 would be considered to be noncreditworthy. The difficulty for
lending officers is with scores that fall between 1.81 and 2.99. This is known as
the zone of ignorance and represents sampling errors between the two popu-
lations. In this zone, good loans could be classified as bad, and bad loans could
be classified as good.
Statistically, the former is known as a type 2 error while the latter is known as
a type 1 error. Each situation is an opportunity cost to the lender, although the
latter has a more serious explicit cost. Ways of dealing with the zone of ignorance
differ among lending organisations, but the following would be considered:
• the risk profile of the lending organisation
• the lending organisation's relationship with the potential borrower
• the judgement of the analyst.
The following example should assist in your understanding of this technique.
Imagine you are a lending officer with XYZ Bank. You are given the following
information about Company ABC:
Assets Liabilities
Current assets $10 Current liabilities $9
Noncurrent assets $20 Noncurrent liabilities $15
Shareholders' funds $6
You also know that earnings before interest and tax are $2 and sales are $35.
Would you lend to the company if you followed the Altman method?
Variable Result
Xl (1 0-9) =0037
30 .
6
X2 30 = 0.2
2 .
X3 30 = 0.067
6
X4 24 =0.25
Xs = 1.67 times
Before providing the solution to this example, we should point out that such
a calculation may involve making assumptions. This is not unusual, but care
should be exercised in arriving at the assumptions. In this example, we have
assumed (given lack of information, which also is not unusual) that:
• the equity on the statement of financial position is all retained earnings
• the equity on the statement of financial position is also the market value of equity.

We can now complete the exercise. Using the formula for Altman's Z score,
we have:
Z = 1.2X 1 + 1.4X 2 + 3.3X, + 0.6X4 + 0.999Xs
= 1.2(0.037) + 1.4(0.2) + 3.3(0.067) + 0.6(0.25) + 0.999(1.67)
= 2.36.
The score falls into the zone of ignorance (between 1.81 and 2.99).
Depending on XYZ Bank's tolerance in the zone of ignorance, there is a strong
likelihood that you would lend to this company. If, however, you made different
assumptions regarding equity (retained earnings and the market value of
equity), then the Z score would most likely fall below the lower bound of 1.81.
Since the Z score was developed in 1968, there have been developments in its
form:
• A private firm Z score has been developed, which takes into account that the
market value of equity is not available. The major change is in X4, where the
book value of equity is directly substituted for the market value of equity.
• It has been recognised that nonmanufacturing firms, without assets, are
prejudiced against because assets are used in many of the ratios. Two major
changes are thus made: Xs is dropped and the book value of equity is used
for X4.
• Finally, a second generation model, known as ZETA, was developed in 1977
to account for changes in business failure. The most significant change in
this model is the recognition that the size of the firm makes a difference. The
general result has been that the larger the firm, the less likely it is to fail. This
results occurs because smaller firms are often newer and more likely to enter
bankruptcy.
While these newer models have different functional forms given their dif-
ferent variables, they follow the same principles. Finally, it should be noted that
many other models follow the same techniques, particularly credit scoring, in
assessing credit risk.
Usingstockprices
The criticism of Altman-style models, which use financial ratios, is that they
use data from financial reports. The data are thus 'old' and backward looking,
whereas default is about looking forward to potential defaults. If we consider,
however, that the market price of assets and the market value of debt are for-
ward looking, then using this information, we may be able to calculate the
default probability. This is how KMV Corporation's expected default frequency
model works, using option modelling.
The lending proposition of a bank is to lend money to an organisation that
uses the funds. If the firm uses the funds well, then the value of assets will rise
and the borrower will repay the loan. If, however, the funds are used badly, then
the asset value will fall, the value of the asset may be unable to repay borrow-
ings and a default will occur. If we graph this scenario, we find figure 11.2
(page 342). (Note that there is an upper bound on returns from lending.)
I
>-
111
a.
Borrowing Asset price
FIGURE 11.2 A sold put option in bank lending
Those who are familiar with option modelling will see that this is a sold put
option on assets where the equity value will be a function of the market value
of assets and its volatility, the liabilities of the firm, interest rates and the term
to maturity, in terms of option pricing. The default decision becomes an issue of
how close the market value of assets is to the default point. The aim then becomes
to predict the probability that asset values will fall below the default point.
I f we look at the lending decision from the equity holder's point of view, then
the pay-off diagram shown in figure 11.3 would result.
Value of
asset
FIGURE 11.3 A call option representing the equity holder's interest in bank lending
Interpreting this graph is simple. When borrowing money, the equity holders
would repay their loan if the asset value were greater than the liabilities. Again,
those with a familiarity with option pricing will see that this is a call option on
the assets of the company.
The difficulty with the approach is that there are two unknowns in the formu-
lation; the market value of assets and asset volatility. If we exploit the relationship
I 342 Part 5: Assessmentand managementof risk I

between assets and equity in the option pricing formula, as well as the volatility,
then we can solve the two unknowns. The functional forms would be:
Price of risky debt = Option function (asset value, asset volatility,
capital structure, interest rate, term to maturity)
Price of risky debt = Option function (asset value, asset volatility,
capital structure, interest rate, term to maturity).
We are assuming that the asset value and its volatility can be inferred from
the option pricing model. We can now solve the two equations and find the
values attached to assets and volatility. How do we use this number? The
following principles apply.
The net worth of an organisation is simply the market value of assets less
than the default point. Under the popular KMV Corporation method, the
default point is all the current liabilities plus half the long-term liabilities. This
recognises that not all debt is due at the same time; the presence of long-term
debt does provide breathing space in times of financial stress. The net worth,
however, should be considered in terms of business risk. In other words, some
firms can afford greater leverage (that is, risk) than others can. The market of
assets magnifies the effect of the volatility on the asset size. We can, however,
now calculate how far we are from default:
Market value ]_ (Default point)

( of assets
Distance of default = - - -- - -- - -- - -- -
Market value ](ASset volatility)
( of assets
This provides the distant to default, or the number of standard deviations to

default. Once we have this figure, we can estimate the default probability. It is
important to understand that some of this technology is proprietary to KMV
Corporation, which maintains a database of 100000 companies and 2000 inci-
dents of default or bankruptcy.
If our distance to default turns out to be four standard deviations, for
example, then the KMV Corporation database will indicate the proportion of
firms with four standard deviations distance to default that actually defaulted.
This proportion is known as the expected default probability:
.. Number of default firms

Expected default probabIhty = 11f f I
A Hms 0 samp e
The following sample estimation of default is taken from a technical docu-
ment made available by KMV Corporation. There are three steps:
1. estimate the current value and volatility of the firm's assets
2. determine how far the firm is from default (its distance from default)
3. scale the distance to default to a probability.
Consider Philip Morris Companies Inc., which at the end of April 2001 had a
one-year estimated default frequency of 25 basis points (0.25 per cent). The cal-
culation made is as shown in table 11.3.
TABLE 11.3 Sample calculation of estimated default frequency - Philip Morris Companies Inc.
Variable Value Howcalculated/information

accessed
Market value of $110688 million Share price (accessed from the stock market) X shares outstanding
equity (from the annual report)
Book liabilities $64062 million Statement of financial position (from the annual report)
Market value of $170 558 million Derived from the option pricing model *, as described earlier in
assets the chapter
Asset volatility 21% Derived from the option pricing model, as described earlier in the
chapter
Default point $47499 million Calculated as all short-term liabilities plus half the long-term
liabilities, as described earlier in the chapter
Distance to 3.5 Calculated from the ratio of , which comes from the
default
formula using the information derived above:
l( Market value)
of assets
_ (Default point)
Distance of default =- - - - - - - - - - - -
l( Market value )(ASset volatility)

of assets
Estimated default 25 basis points Empirical mapping between distance to default and default
frequency frequency
;; FMV lIses a standard Black-Scholes option pricing model. Students wishing to examine this model should refer to a text
on pricing derivatives.
Again, we note that the default probability, as in the Altman case, is indepen-
dent of the loan size.
Portfoliomanagement
While much of this book is devoted to the analysis of a single loan or a
number of loans to the same borrower, attention has been given in recent
years to the effect (in terms of the risk-return pay-off) of adding loans to
an existing portfolio of loans. Concentration risk has gained much attention
in this regard.
A portfolio of loans can be viewed as a portfolio of assets, and the
proposition has been that managers can use modern portfolio theory to
manage the loan portfolios. The issue becomes how to manage new loans
that are highly positively correlated to the rest of the portfolio. In good
economic times, this is not a problem; if there is an economic downtown,
however, the majority of the loan portfolio could be exposed to the same
factors. In particular, smaller financial institutions that operate in a limited
geographical area are subject to this risk.

Portfolio management of loan portfolios is nevertheless a relatively new
phenomenon and there are questions about the relevance of modern portfolio
theory to lending portfolios.
• Are the assumptions under which modern portfolio theory operates
applicable to loans?
Modern portfolio theory assumes that the distribution of returns is normal.
Loans, however, are characterised by having a one-sided distribution
because the minimum return is assumed to be zero in default.
Modern portfolio theory assumes that all the assets in the portfolio can
be revalued. This is simple in equity markets because shares operate on a
share market. For bank loans, however, this is difficult because the loans
are not traded on an exchange.
• Is the environment under which modern portfolio theory operates the same
as that for lending portfolios? In terms of equity portfolios, for example,
investors have the option of purchasing or not purchasing a share at a given
price and return. Lending portfolio managers do not have such luxury,
because they inherit loans approved by lending managers.
• Is concentration risk a problem? It could be argued that concentration risk is
a result of concentrating lending in expert areas and that diversification
could be conducted in different ways, such as by geographic region rather
than by industry or company type.
There are a number of different models for portfolio management, including
the risk-adjusted return on capital, the Altman Sharpe Index approach and
CreditMetrics™. The next sections are not designed to illustrate the flaws of
existing methods, but will explain the approaches used. There is no doubt that
better methods will become available.
Risk-adjusted
returnoncapital
One of the earliest attempts to address the problem of approving loans was
prompted by the introduction of capital adequacy. While lending institutions are
required to set aside capital for each class of loan for capital adequacy purposes,
not all loans are equal. If two loans - one housing and the other corporate, for
example - have the same interest rate, then the lending institution would prefer
the housing loan because less capital would need to be put aside under the current
capital adequacy gUidelines (although changes to the guidelines are proposed).
Bankers Trust (BT) originally developed the risk-adjusted return on capital.
It recognised that capital was put aside for each loan and suggested that a
hurdle rate for loans needed to be achieved before a lender added the loan to
the portfolio. The approach is a return on equity approach, rather than portfolio
approach, but has been used for portfolio purposes. It can be justified on the
basis that loans of various risk classes are added to the portfolio if they provide
the appropriate return. This can be expressed as:
Income from the loan for one year

Risk-adjusted return on capital =
Capital at risk
The formula is deceptively easy but has many treatments. The following
questions are among the issues:
• What income from the loan should be included? If the loan attracts further
business, should this income be included?
• How is capital at risk defined? BT uses a duration number (see below), but
many other methods can be used. A more accurate representation that could
be used is the value-at-risk calculation derived by CreditMetrics™ (see page
348).
BT uses a simple duration number to define the capital at risk as follows:
_ D
T -- L1 +RL
where
L = the percentage change in the market value of the loan over the
period
-DL = Macauley duration (which is the weighted average receipts on a
security or loan, where the weights are present values)
= the maximum discounted change in the credit risk premium over
1 + RL the period.
This can be re-arranged to be:
xL x--
L 1+R L
where
= the capital at risk.
A simple example is as follows: the base rate for a loan is 8 per cent and the
loan also has various fees that total 0.5 per cent. The duration of the loan is two
years and is 100 basis points. The loan amount is $100000.

1+ L
The income is the total of the various fees applied to the loan amount:
0.5% X $100000 = $500.
The capital at risk is as follows:
=2 x 100 000 x 1%
= 2000
therefore:
· k -a d'Juste d return on capIta

RIS 500
. 1 = 2000 = 25°/
10.
As long as the lending institution's hurdle rate (return on equity) is less than
25 per cent, then the loan would be added to the portfolio. Hurdle rates are
normally defined by lending institutions as the return on equity.

The last issue that we need to consider is that of scarce capital. A finan-
cial institution cannot continually lend, because capital is finite. What
does a lender do if, for example, capital is exhausted and a loan appli-
cation exceeds the required hurdle rate? The obvious answer would be to
raise new capital, but this takes time. This is where the portfolio approach
applies. Most financial institutions would allocate marginal capital for
each loan, in recognition that it takes time to raise new capital for lending
purposes.
Altman'sSharpeIndexapproach
Altman's approach to portfolio management is characterised by the Sharpe
Index where the portfolio return is adjusted by the portfolio risk. This approach
is not unlike the risk-adjusted return on capital for a single loan. Altman's
approach is simple: optimise the Sharpe Index subject to various constraints. It
is important then to identify the various components.
The portfolio return is the weighted average return of each asset in the port-
folio. This recognises that the risk that a loan brings to a portfolio depends on
the amount of the loan relative to the portfolio. The return of each asset is defined
as the promised yield to maturity, less expected annual loss. There are many ways
in which to calculate the expected annual loss, with many financial institutions
using their historical experience for each loan type. To calculate annual losses,
Altman uses an insurance concept called mortality rates and losses. This is the
risk premium implied by the default experience of the credit rating of the loan.
Financial institutions, therefore, would need to develop ratings for those loans
without a credit rating.
Using Altman's terminology, the problem can be broken into steps. The
first step is to calculate the return on the portfolio, using the following
equation:
N
Rp= L XjEARj
i= 1
where
Rp = the return on the portfolio
Xj = the proportion of each asset invested
EARj = the expected annual return.
The next step is to calculate the variance of the portfolio using the following
equation:
N N
Vp = L L XjXpjO"jPU
i=lj=l
where
Vp = the variance of the portfolio.
Then, maximise the following relationship, which is the Sharpe Index:
R J
11= _I-
F;
where
N
LXi 1 =
i = 1
Rp ;:: the target return
Xi the individual bond investment limit.
Care must be taken when using this and other techniques, to ensure adequate
data are available, particularly for portfolio variances. Otherwise, other forms of
variance would need to be used.
CreditMetrics™
CreditMetrics™ is a portfolio method that is growing in popularity. Its great
attraction is that it incorporates the fact that credit risk changes over time. The
technique would be familiar to those who have an exposure to J. P Morgan's
RiskMetrics™ and value-at-risk methods. CreditMetrics™, also developed by
J. P Morgan, seeks to model portfolio risk by tracking value changes in lending
assets by assessing the probability of credit changes.
CreditMetrics™ is best understood by using an example. The following
example is taken from a J. P. Morgan technical document (available for free on the
website www.riskmetrics.com.au).
Suppose we have a BBB-rated bond with a maturity of five years. The bond
has a coupon of 6 per cent. The credit rating of this bond over a period of time
can rise to AAA, fall to CCC or default. Each rating change has a probability, as
shown in table 11.4.
TABLE 11.4 One-year transition matrix
Initial Ratingatyear-end(%)
Rating AAA AA A BBB BB B eee Default
AAA 90.81 8.33 0.68 0.06 0.12 0.00 0.00 0.00

AA 0.70 90.65 7.79 0.64 0.06 0.14 0.02 0.00
A 0.09 2.27 91.05 5.52 0.74 0.26 0.01 0.06
BBB 0.02 0.33 5.95 86.93 5.30 1.17 0.12 0.18
BB 0.03 0.14 0.67 7.73 80.53 8.84 1.00 1.06
B 0.00 0.11 0.24 0.43 6.48 83.46 4.07 5.20
CCC 0.22 0.00 0.22 1.30 2.38 11.24 64.86 19.79
Source: Standard & Poor's 1996, CredifWeek, 15 April.
Table 11.4 shows that the most obvious scenario will be that the bond stays
at the same rating, with little probability of it moving higher. (These credit
migration probabilities are available from Standard &: Poor's.)

Given a yield curve and assuming that each credit rated bond has a coupon of
6 per cent, we can calculate the value of each bond as shown in table 11.5.
TABLE 11.5 Distribution of value of a BBB par bond in one year
Year-end
rating Value($) Probability
(%)
AAA 109.37 0.02

AA 109.19 0.33
A 108.66 5.95
BBB 107.55 86.93
BB 102.02 5.30
B 98.10 1.17
CCC 83.64 0.12
Default 51.13 0.18
Source: J. P. Morgan 1997, CreditMetrics ™ - Technical

Document, www.riskmetrics.com.p.11.
Using a zero coupon yield curve, we can calculate the zero coupon rates as
shown in table 11.6.
TABLE 11.6 Zero coupon rates, by credit rating category
Category Year1 (%) Year2 (%) Year3 (%) Year4 (%)
AAA 3.60 4.17 4.73 5.12

AA 3.65 4.22 4.78 5.17
A 3.72 4.32 4.93 5.32
BBB 4.10 4.67 5.25 5.63
BB 5.55 6.02 6.78 7.27
B 6.05 7.02 8.03 8.52
CCC 15.05 15.02 14.03 13.52
Source: J. P. Morgan 1997, CreditMetrics™ - Technical Document,

www.riskmetrics.com, p. 27.
The above interest rates are taken from the corporate bond market for each of
the credit ratings. Note that zero coupon rates are used rather than par coupon
rates. While standard discounted cashflow method is used to reach the above
values, you need to note the following treatments used by CreditMetrics™:
• The first year's cashflow is not discounted.
• The subsequent cashflows are discounted on an annual basis, despite most
bonds being semi-annual in nature.
• The value of the bond in default is not a discounted cash flow; rather, it
represents a recovery rate of 51.13 per cent. This demonstrates that not all
cash flows are received and that some need to be estimated. The value of the
BBB-rated bond, therefore, will be:
6 6 106
+ ------ + ------ + ------
107.55 = 6 + (1 + g041) (l + 0.0563)4'
(l + 0.0467)2 (l + 0.0525)3
The previous equation is simply the normal discounted cashflow formula
that is used in finance:
Cashflow from bond
n
(1 + Zero coupon rate)
where
n = the year.
Figure 11.4 shows how the distribution appears visually
BBB
0.900 III
Z
0.100
>-
(J 0.075
c
Q)
::I
C"
...
Q) 0.050
LL
0.025
AAA
0.000
50 60 70 80 90 100 110
Revaluation at risk horizon
FIGURE 11.4 Distribution for a five-year SSS-rated bond in one year
Source: J. P. Morgan 1997, CreditMetrics™ - Technical Document, www.riskmetrics.com. p. 23.
You will notice that the distribution is very skewed, not normal. This pre-
sents some statistical issues, but we will assume that the distribution is normal.
Completing the calculations, we can find the standard deviation of the distri-
bu tion, as shown in table 11. 7.
TABLE 11.7 Standard deviation calculation - calculating volatility in value due to credit quality changes
Probability-
Probability Newbondvalue Probability- Difference
01 weighted
01state pluscoupon weighted
value valuefrommean difference
Year-end
rating (%) ($) ($) ($) squared
AAA 0.02 109.37 0.02 2.28 0.0010

AA 0.33 109.19 0.36 2.10 0.0146
A 5.95 108.66 6.47 l.57 0.1474
BBB 86.93 107.55 93.49 0.46 0.1853
BB 5.30 102.02 5.41 (5.06) l.3592
B 1.17 98.10 LIS (8.99) 0.9446
CCC 0.12 83.64 1.10 (23.45) 0.6598
Default 0.18 5l.13 0.09 (55.96) 5.6358
Mean = $107.09 Variance = 8.9477

Standard deviation:= $2.99
Source: J. P. Morgan 1997, CreditMetrics™ - Technical Document, www.riskmetrics.com. p. 28.

The following are explanations of the terms in table 11. 7:
• year-end rating: the credit rating at the end of year one
• probability of state: the transition probability indicated by Standard &: Poor's
as per table 11.4
• new bond value plus coupon: the value of the bond as per the yield curve in
table 11.6
• probability-weighted value: the transition probability multiplied by the value
of the bond. (The sum of this column is the transition-weighted value mean.)
• difference of value from mean: the new bond value less the value-weighted
mean
• probability-weighted difference squared: the difference squared multiplied by
the transitional probability. (The sum of this column is the value-weighted
variance and the square root is the standard deviation.)
The standard deviation is the stand-alone credit risk of the BBB-rated bond. It
is the unexpected loss of the distribution and, technically, it is the capital that a
lending institution should put aside.
Here, we are concerned about the capital at risk due to credit risk changes.
This is measured as the amount that can be lost depending on the number of
standard deviations. A 1 per cent value at risk is one standard deviation 0.65),
while a 5 per cent value at risk is two standard deviations (2.33). 0.65 and 2.33
are the number of standard deviations under the normal curve.) In terms of the
calculations, the capital at risk becomes as follows:
• 5 per cent value at risk: 1.65 x 2.99 = $4.93
• 1 per cent value at risk: 2.33 x 2.99 = $6.97
In the next chapter, we will deal with capital adequacy. It is sufficient to say
here that capital adequacy deals with unexpected losses and would require that
banks put aside $8 million. (Under capital adequacy gUidelines, this loan would
have a 100 per cent risk weighting, requiring 8 per cent to be put aside as
capital.) Under a more 'scientific' method, we see that less capital could be put
aside.
Moving from the stand-alone risk to a portfolio risk becomes a more difficult
proposition because we now need to deal with joint probabilities. This is beyond
the scope of this text, but we can describe the problem if we imagine adding
another bond to the portfolio. The following issues then need to be considered:
• As seen in the stand-alone example, there are eight different possible values.
With a second bond in the portfolio, there would be sixty-four different
values (eight multiplied by eight possibilities of new values).
• We then need to calculate from the transitory probabilities the sixty-four
probabilities. Given the correlations among the credit correlations, it is not a
matter of multiplying the probabilities as if they are independent.
• We then calculate the mean and variance of the value of the distribution. As
loans are added to the portfolio, the calculations become more complicated.
Now we have moved through the computational issues, we can recap with
the following procedure to calculate the portfolio risk of a lending portfolio for
a credit-rated bond.
1. Define the portfolio as individual assets
2. For each asset, define the cashflows and calculate the present values for each
potential state, using a zero coupon yield curve
3. Using a transition matrix, calculate the probability-weighted present value
and standard deviation. These three steps could be construed as one stage
because they calculate the stand-alone risk of each loan
4. The next stage is to calculate the portfolio risk by executing the above pro-
cedure for the joint probabilities for a loan in the portfolio to derive the
standard deviation of the portfolio.
While the CreditMetrics™ approach overcomes some of the stated objections
to using modern portfolio theory (that is, the assumptions of normality of dis-
tributions), it has its own concern: like many other methods, it always involves
the problem of valUing bank loans.
Managingtheportfolio
In this chapter, we have moved from analysing the single loans to analysing the
overall portfolio risk. The question now becomes: what does the lending man-
ager do if he/she finds unacceptable concentrations of risk? To put this into
more familiar terms, what does the portfolio manager do if he/she finds that the
lending assets fail to sit on the efficient frontier?
In these circumstances, the lending portfolio manager would need to shed
some of the assets that cause some of the problems. For many years, the only
technique was to sell the loans off the statement of financial position. Known as
securitisation, this technique was limited to various selected assets. The develop-
ment of the financial markets, however, has given rise to a new class of derivative
instruments called credit derivatives. We will now discuss both techniques.
Securitisation
Securitisation is a method of packaging the cashflow from an asset into an
investment (not collateral) security and selling it to investors. The most recog-
nised securitisation structures are those that package home loans, but many
other structures are available. These include packaging cashflows from:
• utility bills such as electricity and water bills
• royalties such as those of recording artists
• car loans and leases
• rentals from large, well-tenanted commercial buildings.
Financial institutions securitise for different reasons and are not restricted to
credit risk management. This is particularly the case in Australia, although
lenders in countries such as the United States use securitisation or similar tech-
niques such as loan sales to remove risk concentration. In Australia, securi-
tisation is also used for:
• capital management
• liquidity management
• interest rate risk management.
I 352 Pari 5: Assessmentandmanagementof risk I

The usual reasons for secuntlsation in Australia are capital and liquidity
management. Note that securitisation, contrary to appearances, does not mean
selling the lending off the statement of financial position. The two main types of
securitisation structure are:
1. pass through structures
2. pay through structures.
The type of structure used depends on the purpose of securitising lending
assets. Before discussing these structures, it is important to recognise the charac-
teristics of the following types of asset that can be securitised:
• The assets must have high-quality cashflows; in other words, there must be a
low probability of default. This makes home loans an attractive asset because
they have historically low default rates.
• The lending assets have to be homogenous, which means they have the same
risk profiles. Again, home loans have a similar risk profiles.
• Credit rating agencies also impose conditions on structures when they apply
ratings.
Individual lending assets must be seasoned (which usually means that at
least one repayment has been made) and must have insurance (which
usually means, for home loans, that the loan is mortgage insured).
On a portfolio basis, structures will normally be penalised if there is
geographic risk.
Passthroughstructures
The major characteristic of pass through structures is that the lending assets
are completely sold off the statement of financial position. Those financial
institutions that are using securitisation for capital management purposes
favour these structures, which have the following component (figure 11.5):
• the owner of the assets
• a special-purpose vehicle through which the assets are sold
• a trustee/manager that manages the assets and their cashflows. This
involves receiving the cashflow from the lending assets - for example, the
principal and interest repayments that would be received via the lending
institution - and passing them onto the investor. The trustee/manager is
also responsible for investing surplus cashflow received to maintain the
value of the asset.
• investors who buy the security.
Lending Special-
. . Receives purpose .. Receives
institution
cash vehicle cash
Investors
Sold to. Packaged Sold to •
Portfolio
securities
FIGURE 11.5 Process for pass through structures
.1
In terms of the asset pool, there are two types of structure:
1. static pools
2. dynamic pools.
A static pool has a fixed number of assets in the pool. To maintain the value
of the pool, the pool is either insured for the value or overcollaterised. Over-
collaterisation means a greater value of assets is put into the pool than the value
for which the pool is to be sold. This is obviously at a penalty to the lender
wishing to securitise assets. Both measures are important to investors, who
would be concerned that loans would lose their value through pre-payments or
default.
Dynamic pools have assets with maturities that are shorter than the actual
securitisation structure. As cashflows come in from the lending asset, the trustee/
manager re-invests the proceeds to maintain the value of the pool. This often
requires the trustee/manager to carry out risk management or purchase guaran-
teed investment contracts (known as GICs in the market), which guarantee a
yield.
Paythroughstructures
Pay through structures are not much different from pass through structures,
particularly in terms of the cashflows. The one major difference is that the
lending institution does not sell the assets off the statement of financial pos-
ition; rather, it packages the cashflows into the special-purpose vehicle.
Pay through structures are more popular with institutions that are not regu-
lated by the Australian Prudential Regulation Authority. The reason is that if the
purpose of the securitisation were capital management, then the regulator would
not consider the asset as having been removed from the statement of financial
position using this structure. The most popular assets that are securitised
through these structures are credit card receivables from retailers and car lease
receivables from nonbank lenders.
Securitisation
andcreditriskmanagement
The question now becomes: how does securitisation help credit risk manage-
ment? The most obvious purpose for using securitisation for credit risk manage-
ment is to sell off concentrations of credit risk. Financial institutions, having
identified a concentration of lending assets, can sell off these assets through
securitisation vehicles. At this stage, the assets that can be securitised are limited
to hOUSing loans, credit card receivables and car lease receivables, but the over-
seas experience reminds us that the variety of assets that can be securities will
slowly rise over time.
Three other issues need to be kept in mind when securitising via pass
through structures:
1. It is important that there is no recourse, either legal or moral, to the lender
if the securitised loan defaults. The Australian Prudential Regulation
Authority has guidelines regarding recourse. Apart from the regulatory
requirements, the lending institution will not have removed the credit risk if
investors are able to claim recourse.

2. An often-overlooked issue is that when credit risk is sold off, fair value for
the credit should be received. This may seem to be a liquidity issue, but it
becomes a credit issue because the reward-risk issue arises when assets are
sold at deep discounts.
3. Securitisation also brings up a relationship issue for the lender and bor-
rower. When a lending asset is securitised, the institution may be required
to inform the borrower that its loan is being sold. This may be viewed
negatively by the borrower, particularly in the corporate lending market.
Much of this problem is overcome by assigning the asset to special-purpose
vehicles, which means that the title remains with the lending institution.
There is a growing tendency in the corporate lending markets to use credit
derivatives to layoff credit risk, because this does not disturb the relation-
ship between the lending institution and the borrower. We will now deal
with these instruments.
Creditderivatives
Credit derivatives are a set of financial instruments that allow participants in
the financial markets to either assume or remove credit risk to a portfolio
without buying or selling the lending asset. Credit derivatives have a major ben-
efit over securitisation. With most securitisation structures, the lender loses the
relationship with the borrower, which is unacceptable with many loans, par-
ticularly with corporate customers. Credit derivatives allow the removal of
credit risk without breaking the relationship.
The financial institution that lends money but wishes to layoff the credit risk
is known as the protection buyer, while the institution that assumes the credit
risk is known as the protection seller. In many respects, the financial institution
is insuring the statement of financial position against credit risk, much like
insuring the statement of financial position against changes in interest rates.
Many credit derivatives have a collary in the interest rate derivatives market.
There are many different credit derivatives, but they fall into three main cate-
gories: (1) credit default swaps; (2) total return swaps; and (3) credit options.
A credit default swap acts like an insurance policy: for a periodic fee, a
lender can hedge a loan with a protection seller, who would pay an agreed
amount on the instigation of a credit event. The types of credit event
covered are normally negotiated between the protection seller and buyer, and
could include:
• bankruptcy
• credit rating change
• capital structure changes
• default on a loan
• changes in credit spreads above an agreed level.
Figure 11.6 (page 356) shows how the credit default swap works. The residual
payment is normally defined as the face value of the lending asset less the market
value (or recoverable value) of the loan.
Periodic fee
Protection Protection
buyer seller
Default payment
FIGURE 11.6 Credit default swap
While the credit default swap structure looks like an insurance policy, the
total return swap looks more like an interest rate swap, as shown in figure 11.7.
Under this swap, the protection seller pays the protection buyer any losses in
market value on the reference loan (or, in the case of the market value of the
asset increasing, the protection seller receives the increased value). In return,
the protection buyer pays a funding rate such as the London Inter Bank Offer
Rate (LIBOR) or BBSW * The asset on the statement of financial position of the
financial institution maintains its value regardless of any change in credit rating
(up or down).
Change in market
Protection value of loan Protection
buyer seller
Funding
FIGURE 11.7 Total return swap
Some credit options operate as normal options where the strike price is based
on credit spreads widening. They are not unlike a credit default swap, except
the fee is paid in full at the beginning of the derivative rather than over the life
of the instrument. If the fee is paid upfront, then the derivative is generally
referred to as an option; otherwise, it is a swap.
The protection sellers tend to be a limited number of institutions, mainly
banks (both domestic and international). In offshore markets, many insurance
companies are now protection sellers, gaining diversification benefits by
moving into new markets. Australia is expected to move in the same direction.
In the near term, however, given that banks are using only credit rated bonds,
the market is expected to be limited as financial institutions attempt to layoff
the same credit risk. This will be a problem until the market deepens. The
following are among the other major problems:
• Good-quality pricing data are not available.
• The pricing models have not been tested during periods of financial distress.
• Where numerous credit derivatives have been written on a particular asset, if
that asset defaults, then the value could paradoxically be higher than the
default value because the asset (loan) would be deliverable.
* BBSW is a page on the Reuters information system that provides average hank bill rates over a range of
maturities to 180 days.
I 356 Part5 Assessmentandmanagementof risk I

• Credit derivatives, operating in an illiquid market, cannot be easily valued.
• With the risk now removed from the statement of financial position, the incentive
for the financial institution to monitor the reference asset is diminished.
• At this stage, the Australian Prudential Regulation Authority penalises any
hedge using a credit derivative if it does not match the maturity of the
underlying reference asset. Many protection sellers, being risk averse, will
write protections for maturities less than those of the reference assets.
banks in Australia are

in being able to assess com-
. of the five biggest Australian banks

fiper cent of their loans carried
.... years. . ....
is the Australian arm of Zeta Services Inc., which has
of credit risk rating for the past seventeen years. Its
per cent of the top fifty US banks and Zeta is a con-
Board.
director of.' .. Services, Mr Graham Soper, said the sample
had highlighted the need for banks to have an
tncletJlenaellt :5f their loan books.
results showed a major flaw in the Reserve Bank's
',:' . ... .. ". requirement that chief executive officers of banks sign
ternal risk management systems.
t is going to sign off a declaration that their risk man-
:m,adequate', he said .
• external, objective test of their credit risk management.
it because they don't have the software to be able to
a loan book and give them a rating.'
who spent twenty years in insolvency and corporate reconstruction
work before starting a company called Corporate ScoreCard, said much had
been written about the risks to banks from derivatives while ignoring the
dangers from 'the common old garden corporate loan'.
'People seem to have ignored the enormous potential for banks to lose money
in corporate lending', he said .
... the top six banks alone wrote off $17.45 billion between 1991
and hit a peak of bad loans in 1992 of $25.7 billion.
Mr Soper said the pilot studies of two of the top five Australian banks
found that only 65 per cent of loans matched the Zeta credit risk ratings
whereas in the United States 70 per cent of loans matched the Zeta ratings.
(continued)
Of the remainder of the loans in the Australian samples, half were rated
higher than the Zeta ratings and half were lower.
The chairman of Zeta, Mr Brian Wright, said banks that failed to assess accu-
rately the credit risk of customers ran the risk of either overcharging or under-
charging for risk.
Mr Wright, who had a long experience of dealing with small to medium-sized
enterprises [SMEs] when he was head of the Commonwealth Development
Bank. said Zeta's work had shown that up to 15 per cent of SMEs were far
stronger than the banks thought they were.
Zeta was started in 1979 hy Professor Ed Altman and Mr Bob Haldeman. Pro-
fessor Altman, who is professor of finance and chairman of the MBA program at
the New York University Business School, developed the idea that default or
credit risk could be measured directly from financial statement data.
Zeta Services Inc. in New York licensed the Australian and New Zealand
rights to its software in 1993.
Source: T.Boyd 1995, 'The art of picking losers', Australian Financial Review, 6 November, p. 28.
The above article highlights the veracity of the credit risk management
system. It makes a very important point: differing credit risk management
systems provide different answers. In this case, the divergence is between
in-house systems designed by lending institutions and those available 'off the
shelf'. Is the comparison valid?
It depends. Systems deSigned in-house have the advantage of including those
characteristics peculiar to the lending institution. They can be difficult to keep
current, however, in terms of financial market developments. This is where
off-the-shelf systems are valuable.
There are two points to the article. First, how are lending institutions kept
accountable for the way in which they manage credit risk? Second, the article
implies that banks may experience bad debts five years from 1995, and we are
now starting to observe spectacular corporate collapses that affect lending insti-
tutions.
loan pricing
The discussion on credit risk analysis and portfolio management would be
incomplete without a discussion of the elements of loan pricing. We mentioned
earlier in the chapter that lending as a whole rarely lies on the efficient frontier,
inferring that the interest rate charged on loans does not reflect its risk. This
does not necessarily reflect all lending products, but portfolios as a whole. In
this section, we will highlight the elements that should be considered in loan
pricing:
1. costs of the statement of financial position
2. noncredit risk costs.
I 358 Pari5: Assessment of risk I

andmanagement
Costsofthestatement
offinancialposition
Given that the loan is funded from the statement of financial position, a number of
costs that are generated from the statement of financial position need to be considered:
1. capital costs
2. liquidity costs
3. the cost of funds.
Capitalcosts
Lending institutions charge capital to loans using differing methods. As a base
method, they would set aside capital based on the capital adequacy guidelines.
This would mean that some capital would need to be used when funding a loan.
Investors would require a return on the equity they provide. This cost to the
lending institution is determined by the board of directors.
liquiditycosts
The element of liquidity is often forgotten in the lending equation. While the
Australian Prudential Regulation Authority has relaxed the formal guidelines
for liquidity management, a prudent lending institution would hold a portion of
its assets in liquid securities or cash. This approach implies that liquidity
should be held against every lending asset, depending on the policy.
Costoffunds
When we take the above elements into account, we can calculate the cost of
funds. The required capital and deposits fund the lending and liquid assets. The
following returns would be fixed or set by the market:
• The board sets the return on equity.
• The market sets the return on liquidity.
• The market also sets the cost of deposits.
• The only variable is the return on the loan, which is the balancing figure.
This should become clearer in an example later in the section (page 361).
Noncredit
riskcosts
Lending also involves risks that are not directly related to the statement of finan-
cial position but affect the cost of the loan and thus its price. These risks include:
1. interest rate risk
2. pre-payment risk
3. origination costs.
The first two risk types occur generally when the loan is a fixed interest loan,
while the third occurs with all loans.
Interestraterisk
Many financial institutions provide the majority of their loans on a variable
basis and fund these loans with at-call deposits. As interest rates rise, many bor-
rowers tend to want to switch to fixed interest rate loans. In a rising interest
rate environment, the costs of deposits also rise. If the lending institution does
not take this into account, then a loss could arise.
There are a number of solutions to this scenario. The institution can fund the
loan from term deposits (or similar instruments) of the same maturity, obvi-
ating the interest rate risk. The longer the maturity, however, the more difficult
it is to raise term deposits. If term deposits can be raised, then that would be
the cost of these funds.
If funds cannot be raised, then the alternative would be to execute a deriv-
ative that would fix the rate. Likewise, the rate at which the derivative is fixed
would be the cost of funds.
Pre-payment
risk
The opposite situation to interest rate risk is pre-payment risk. Again, this is a
risk only for fixed rate loans, but in this instance when interest rates fall. When
interest rates fall, many borrowers of fixed rate loans seek to refinance their
loans at lower rates. If successful, the financial institution incurs a loss because
it is unable to reinvest the funds at the same rate. Further, if the cost of funds
has been fixed by term deposits or a derivative, then this arrangement might
have resulted in a relatively high cost of funds.
There are two alternative solutions to this phenomenon. The lending
institution can estimate the average cost of pre-payment risk and add this
cost to the loan (although this may make the loan uncompetitive). More
often, the lending institution specifies a penalty that should cover the
majority (if not all) of the costs. This penalty is easy to calculate and easy
to understand.
The economic solution, however, is to calculate the present value of the
cashflow on pre-payment, with the lending institution receiving a penalty or
paying a benefit depending on the interest rate of the loan and current
interest rates.
Originating
andoperatingcosts
The cost of marketing and then monitoring the loan needs to be incorporated
into the loan. The more complex and risky the loan, the more monitoring it
requires. This effort should result in a higher interest rate being applied.
Creditcosts
We have deliberately not addressed credit costs first. Hopefully, you will observe
that the margin over base rates is more than simply credit risk. Credit risk,
nevertheless, makes up an important element in loan pricing. The two elements
in default risk pricing are:
1. expected losses
2. unexpected losses.
Expected
losses
Lending institutions always expect some loans to default. We cannot predict the
future, and a loan that seems good today can default later as a result of unfore-
seen events. Lending institutions, given their experiences, expect some loans to

default. They can price their expected losses into the loan price using the
following formula:
Expected losses = Default probability x (l - Recovery rate).
Both the default probability and recovery rate for the loan type would be
determined from the lending institution's experience (or, in some cases, credit
rating agencies).
Unexpected
losses
It is more difficult to deal with unexpected losses. These losses are generally
said to reflect the volatility of expected losses and thus change from period to
period. The tail of the CreditMetrics™ distribution shown in figure 11.3 could
indicate unexpected losses.
Unexpected losses cannot be priced. The correct way to deal with them is to
set capital aside (much like capital adequacy) and price unexpected capital as a
return-on-equity issue.
loan pricing- anexample

Now we have identified all the elements of a loan, we can consider the
following example. We will also examine what occurs when the wrong relation-
ships are assumed. The price of a $150000 five-year hOUSing loan needs to be
considered. The lending institution determines that there needs to be -5per cent
liquidity against lending assets, which currently earn 4.9 per cent. At-call
deposits are priced at 3.5 per cent and five-year swap rates are at 5 per cent. The
annual cost of operating and managing the loan is $1000.
The lending institution's default probability for housing loans is 2 per cent,
while its recovery rate is 95 per cent. It considers its unexpected losses in terms
of losses that are outside the capital put aside under capital adequacy guide-
lines. Home loans have a small probability of loss and the lending institution
puts an extra 1 per cent aside. To deal with pre-payment risk, the bank charges
an extra 30 basis points.
What would the price of the loan be if investors require an after-tax return on
equity of 20 per cent and have a tax rate of 30 per cent?
It is important to view the pricing of the loan in stages. Our first step is to
calculate the return on equity. Under capital adequacy guidelines, the amount
of capital reqUired is:
$150000 x 8% x 50% = $6000
The above 50 per cent is as per the capital adequacy guidelines. The after-tax
return on equity becomes:
$6000 x 20% = $1200.

We can also work out the amount of liqUid assets, using simple algebra
required under the 5 per cent policy, as shown on the next page.
Liquid assets = Assets x 5%
where
Assets = (Loans + Liquid assets) = ($150000 + Liquid assets)
Liquid assets = ($1 50000 + Liquid assets) x 5% = $7500 + 0.05 Liquid assets
Liquid assets - 0.05 Liquid assets = $7500
0.95 Liquid assets = $7500
Liquid assets = $7500 = $7895.
0.95
We can now construct a first-stage simple statement of financial position as follows.
Assets
Loan $150000
Liquid assets $7895
Total $157895
Liabilities
Deposits $151895
Equity $6000
Total $157895
You will note that the deposits are the balancing figure. Given that we know
all the costs above (except the loan price), we can make the first calculation,
using at-call deposits.
Financial
performance($) Yield (%) Balance($)
Loan 6714.80 4.48 150000
Liquid assets 315.80 4.0 7895
Less interest on deposits 5316.32 3.5 151895

Profit before tax 1714.28
Less Tax at 30 per cent 514.28
Profit after tax 1200.00 20.0 6000
The balancing number is loan financial performance, from which we can

infer the loan rate. It is not immediately obvious that to find the answer, we
need to work backwards from the profit after tax financial performance, to
obtain the balancing figure of $6714.80, which gives a yield of 4.48 per cent.
The other issue to be considered here is that the loan is fixed for five years. If
interest rates rise, then investors will not obtain their 20 per cent return on
equity. In theory, lending institutions should fund these loans at the five-year
rate and transfer price the deposit at this rate, as we will do below. In practice,
this is difficult to do. The following table shows the effect.
I 362 Part5: Assessment of risk I

andmanagement
Financial
performance($) Yield(%) Balance($)
Loan 8993.23 6.0 150000

Less Interest on deposits 7594.75 5.0 151895
We can now deal with the remaining issues and complete a new table.
• The cost of monitoring is $1000.
• Expected losses are as follows:
Expected loss = Default probability x (l - Recovery rate)
= 2% x (l - 95%) = 0.001.
• Extra capital of 1 per cent changes the $6000 capital to $7500.

• There is a 30 basis point charge for pre-payment risk.
Financial Yield Balance

performance
($) (%) ($)
Loan 10 121.81 6.75 150000

Charge for pre-payment risk 450.00 0.30 150000
Less Interest on deposits 7594.75 5.00 151895
Less Monitoring cost 1000.00
Less Expected losses 150.00 0.001 150000
Practicalloanpricing
If this theoretical approach were adopted, then the price of loans would undoubt-
edly be higher than what is observed in the market. Why? There are two major
reasons:
1. Competition often pushes down the price of loans.
2. Lending institutions price the borrower on the whole connection. The fees on
one facility (such as transaction fees on cheque accounts) are often expected
to offset a lower interest rate. Lending institutions often lose money using this
scenario because some of the expected income does not materialise.
Lending institutions need to exercise caution so their good credits do not
subsidise the lesser credits.
8.15 a.m.
I work for the Commonwealth Bank Group as a credit risk analyst. I read the
Australian Financial Review and Sydney Morning Herald as a daily routine.
9.00 a.m.
A submission for the April meeting of the bank's risk committee is due today.
The risk committee is chaired by Mr David Murray and convened every second
month. Issues discussed at the meeting arise from the challenges of integrated
risks (credit, operational, market and liquidity) that the bank is facing in the
short to medium term. My part of the submission concerns the concentration
level of the bank's lending to the Australian commercial portfolio, as well as the
quantitative measure of the risk-return profile of each industry grouping in the
Australian commercial portfolio. (The return measure is the Sharpe ratio and the
risk measure is the portfolio unexpected loss. At individual asset level, risk is
measured by the contribution of risk to the portfolio unexpected loss, accounting
for the diversification of the portfolio.) The submission is a summary result of a
routinely run model, which takes two to three weeks to process. The model pro-
duces vast amounts of information but space reserved in the risk committee sub-
mission is normally three hundred words and one attachment.
10.00 a.m.
I attend a portfolio management team meeting on the subject of portfolio stress
testing. I have to break off work on the risk committee submission because the
meeting is pre-arranged. The executive credit committee and risk committee
requested the portfolio management team to perform portfolio stress testing at
the middle of 2001, in the wave of apparent credit down cycle and big corporate
collapses, which caused the bank to increase its loan loss provision substan-
tially. This task was given more priority as the result of the 11 September 2001
events in the United States. The format of the meeting is brainstorming. One
team member is not entirely happy with the current method of using a credit
migration matrix derived from the Early Warning System (a forecast model that
I run quarterly, to predict the portfolio expected loss in one year), because
gradual migration does not constitute a stress event. Echoing the concern from
the capital management team, one other team member questions the validity of
stress test in reference to its usefulness in capital allocation. He argues that the
stress test should only help the senior management to understand the risks
faced by the bank. The chief manager of the portfolio management team
decides to continue the current method subject to further discussion.
The official meeting finishes at 11.00 a.m. I spend the next half hour talking
about the weekend footy results, the euphoria of the Corporate Games and
gossip such as Justin Timberlake dumping Britney Spears.
I finish work on the risk committee submission by 12.30 p.m. I have lunch at
my desk, while surfing on the Internet, then walk to the Domain after lunch.

2 p.m.
I deal with an e-mail from the Credit Management Unit at the Customer
Services Division regarding the impact of Colonial integration on its agricul-
ture portfolio. It is putting together a working paper to the board, outlining
the current status of agribusiness in Australia and the bank's strategy in
dealing with the new challenges in this area. It is concerned with the current
economic environment and the potential negative impact on its agriculture
portfolio.
3 p.m.
I attend a scheduled meeting with two consultants from Risk Solution of
Standard &: Poor's regarding the proposal to build a national database on loss
given default. The primary purpose of this database is to make the Australian
Prudential Regulation Authority comfortable and may be used to satisfy the
Basel II requirement for advanced status. Today's meeting is the follow-up of a
Melbourne meeting of the major banks. A further meeting is scheduled to cus-
tomise the database structure and definitions. The meeting finishes in just
under one hour.
4 p.m.
I receive a telephone call from the financial control of institution banking to
voice concern with the assignment of R-square (a correlation parameter) to the
business-in-government sector in the running of KMV Portfolio ManagerTM. A
meeting is arranged for 10.30 a.m. on Thursday.
I have a chat with my work partner about a wide range of subjects, while flip-
ping through some industry/economic magazines.
4045 p.m.
Just as I am getting ready to go home, I receive a request to assess a syndi-
cated credit from the office of the bank's chief credit officer. The portfolio
management team does not assess credit generically (that is, on an individual
client's credit quality); rather, we put the applicant into a subportfolio and
examine its impact in terms of change to the risk-return profile of the port-
folio. It takes 45 minutes to finish trimming the relevant data, which are then
input into our portfolio model. I run the subportfolio overnight. Analysis of
the preliminary result is the work of another day.
Source: Mr Harvey Yu, Portfolio Analyst, Portfolio Management, Group Risk Management,
Commonwealth Bank of Australia, 2001.
It can be easy to think that the task of a credit portfolio manager is boring
and mechanical. Most of the tasks carried out by someone in this position are
involved and time consuming. A particular problem is that requests can appear
'out of left field'. Given that an incorrect credit decision may have an adverse
impact on the lender's profits, the credit portfolio manager's task requires
insight and accuracy of judgement.
Summary
1. What is the main benefit of credit risk management?
The major benefit of credit risk management is that it removes the subjectivity
from lending decisions. Ultimately, loans can be assessed on a scientific rather
than human basis.
2. What is Altman's Z score? How is it used?
Altman used multi discriminant analysis to distinguish between two popu-
lations: good borrowers and bad borrowers. A score is constructed using
accounting ratios, then this score is measured against a benchmark.
3. How can stock prices be used to explain credit risk?
The problem with Altman's Z score is that it is considered by many to be
backward looking. KMV Corporation, via its expected default frequency
method, used share prices to predict default. This assumes that share prices
imply all future possibilities regarding the share.
4. How can risk-adjusted return on capital be used for portfolio purposes?
Given that loans require capital, it has been suggested that a portfolio could
be constructed on the basis of the return on capital adjusted for risk. The
method also recognises that capital is a finite resource and marginal capital
can be used to fund a loan.
5. How can the Sharpe Index be used for lending purposes?
The Sharpe Index measures the risk-adjusted return, like the return on
equity method, using traditional portfolio management. Lenders can maxi-
mise their returns using the method, with suitable constraints.
6. Why is CreditMetrics™ useful for calculating the risk of a loan portfolio?
Again, the Sharpe Index can be considered to have problems because some of
the assumptions do not equate well to lending. CreditMetrics™ recognises this
problem, as well as the fact that credit risk is not static.
7. What are the elements of loan pricing?
The elements of loan pricing include the consideration of costs of the state-
ment of financial position, as well as credit risk costs and costs that are not of
the statement of financial position.
Altman Z score, p. 337 CreditMetrics TM, p. 345 put option, p. 342

call option, p. 342 default point, p. 342 risk-adjusted return on
concentration risk, p. 336 duration, p. 346 capital, p. 345
credit default swap, p. 355 expected default securitisation, p. 352
credit derivatives, p. 352 frequency, p. 341 Sharpe Index, p. 345
credit event, p. J55 option modelling, p. 341 total return swap, p. 355
credit migration, p. 348 pass through, p. 353 zone of ignorance, p. 340
credit options, p. 355 pay through, p. 353
I 366 Part 5: Assessmentandmanagementof risk I

uestions
1. Outline the problems of traditional lending methods and possible solu-
tions. Are there any problems with the solutions?
2. Compare and contrast the approach of the Z score model and the KMV
expected default frequency model.
3. Use the following extracts from the Harvey Norman 2000 annual report
to calculate the Altman Z score.
Statement of financial position as at 30 June 2000
Consolidated Parententity
--------------------
2000 1999 2000 1999
($'000) ($'000) ($'000) ($'000)
i:',Current assets
i:Cash 37385 3147
: Receivables 476077 358477 151669 174 576
'Inventories 61001 24599
,Other 13552 9616 6
Total current assets 588015 395839 151675 174576
, Noncurrent assets
"Receivables 9067 8514
::'Investments 10396 37881 55596 55592
Porperty, plant and equipment 547129 388560
Intangibles 590
Other 2567 3747 1131 950
Total noncurrent assets 569749 438702 56727 56542
Total assets 1157764 834541 208402 231118
Current liabilities
Accounts payable 312124 216373 77 64
Borrowings 33591 12401
Provisions 58115 48547 21517 26085
Total current liabilities 403830 277 321 21594 26149
Noncurrent liabilities
Borrowings 203220 152151
Provisions 388 238
Total noncurrent liabilities 203608 152389
Total liabilities 607438 429710 21594 26149
Net assets 550326 404831 186808 204969
Shareholders' equity
Share capital 187792 142869 142869 142869
Reserves 83551 58614
Retained profits 278983 203348 43939 62100
Total shareholders' equity 550326 404831 186808 204969
Statement of financial performance for the year ended 30 June 2000
Consolidated
Parententity
1999 2000
2000 ($'000) ($'000) ($'000)
Operating profit before abnormal item 173897 136843 28881

Abnormal item 7374
Operating profit before income tax 173897 129469 28881

Income tax attributable to operating profit 62626 49344 11406
Operating profit after income tax 111271 80125 17475

Retained profits at the beginning of the financial year 203348 153895 62100
Total available for appropriation 314619 234020 79575

Dividends provided for or paid 35636 30672 35636
Retained profits at the end of the financial year 278983 203348 43939
Basic earnings per share (cents per share) 10.83 7.89
Source: Harvey Norman 2000, Harvey Norman Holdings Limited and its Controlled Entities - Annual Report 2000.
Would you lend to Harvey Norman? What is the difficulty in using the
Altman Z score?
4. Under what circumstances does KMV's expected default frequency
model not work correctly?
5. Explain the limitations of the concept of the risk-adjusted return on
capital.
6. What financial basis does Altman use to construct his portfolio manage-
ment model? Why does he use constraints in maximising the return on
the portfolio?
7. In the example given for CreditMetrics™ (page 345), we calculated
the stand-alone risk for a BBB-rated bond. Using the same data,
calculate the stand-alone risk of a five-year AA-rated bond with a
coupon of 5 per cent. Is there anything about your answer that you
find unusual?
8. Explain the circumstances in which you would use securitisation and
the circumstances in which you would use credit derivatives.
9. Is securitisation a credit risk management tool?
] O. If a protection seller under credit derivatives is assuming the risk of a
loan, why does the protection seller not just provide the loan?
I 368 Part5: Assessment

andmanagement
of risk I
References
andfurtherreading
Altman E. 1968, 'Financial ratios and discriminant analysis and prediction of corporate
bankruptcy', Journal of Finance, 23, pp. 189-209.
Altman, E. I. 2000, 'Predicting financial distress of companies: revisiting the Z-score
and Zeta models', New York University Working Paper, New York.
Beaver, W. 1967, 'Financial ratios as predictors of failure', Journal of Accounting
Research.
Caoeutte, J., Altman, E. & Narayanan, P. 1998, Managing Credit Risk, John Wiley &
Sons, Toronto.
Crosbie, P.& Bohn, J. R. 2001, 'Modelling default risk', www.moodyskmv.com. accessed
May 2001.
Morgan J. P. 1997, CreditMetric™ - Technical Document, www.riskmetrics.com.
Saunders, A. 1999, Credit Risk Measurement, John Wiley & Sons, Toronto.
White, G., Sondhi, A. & Fried, D. 1998, The Analysis and Use of Financial Statements,
John Wiley & Sons, Toronto.
Introduction
Until the] 980s, the then regulator (the Reserve Bank of Australia) had a large
role to play in credit risk issues. The regulator would often dictate maximum
lending rates and direct financial institutions to sectors of the economy that the
government considered needed lending support. While it is difficult to assess
the effects of these actions, the following conclusions can be drawn:
• The sectors that were not specified for lending assistance would have been
subject to credit rationing.
• Lending institutions might have been subject to concentration risk.
• Given the directives of the regulator, banks might have approved marginal
lending applications in the directed sectors.
From the 1980s, however, successive governments dismantled this regime
and moved to prudential regulation. The strictures on interest rate ceilings and
lending strictures were removed and replaced with the less prescriptive require-
ments of capital adequacy, large exposures and credit issues for securitisation
as well as credit derivatives. (Bad debt issues will be covered in chapter 13,
'Problem loan management'.) Regulation was simply established to reduce the
possibility of insolvency of financial institutions, with the onus being on
lending institutions to comply.
Capital adequacy, for example, is a regulation that requires financial insti-
tutions to put aside capital for each loan they approve. This ensures depositors
are protected if borrowers unexpectedly default on their loans. Regulations on
large exposures simply ensure lenders are not overly exposed to anyone coun-
terparty.
It has been proposed that capital adequacy be extended to overcome criti-
cisms of the treatment of corporate exposures. Corporate exposures are cur-
rently rated 100 per cent under capital adequacy, no matter how risky the loan.
This means that a company close to default would have the same risk exposure
as a highly rated corporation. An example would be that HIH and Woolworths
would have the same risk weighting under the current guidelines. It is sug-
gested, however, that credit ratings be used to discriminate credit risk for
capital adequacy purposes. The proposed standards will discriminate against
less creditworthy borrowers. To understand future developments, it is therefore
necessary to understand the credit rating process, which we will address in a
later section.
Since 1998, the regulator for credit risk issues for financial institutions in
Australia has been the Australian Prudential Regulation Authority, which super-
vises institutions known as approved deposit-taking institutions (ADIs). ADIs
include banks, building societies and credit unions. Most issues canvassed in
this section are based on standards or guidelines that are maintained by the
authority.
The Australian Prudential Regulation Authority does not directly address
credit risk. Given that capital adequacy has become the catch-all for credit risk,
however, this discussion will focus on the way in which the authority addresses
credit matters via capital adequacy. Capital requirement is an important tool
used by regulators to assess credit risk, so it is important that you have full
understanding of the present capital adequacy regulation. We will explain this
concept in the next section.
Capitaladequacy
Recent history has shown that financial institutions normally fail as a result of
poor credit decisions. The responsibility for credit decision-making rests with
the board of directors of a financial institution. Given that shareholders elect
the board, this means that shareholders explicitly assume the credit risk
decisions of the institution.
Credit risk would not be a concern if the bank's board and shareholders
invested only their own funds, but the board invests the funds of other people.
These 'other people' are depOSitors, who keep funds in banks but have no con-
trol over the way in which these funds are invested. The control is ultimately
with the board and senior management, and decisions could be taken that are
not in the interest of the depositors. This is known as moral hazard.
Depositors need to be protected against poor decisions by management -
this realisation led to the birth of capital adequacy regulations. Under the base
capital adequacy, financial institutions are required to put aside capital for each
credit risk exposure, whether it is on or off the statement of financial position.
Under capital adequacy, financial institutions are required to put aside a
minimum of 8 per cent of capital for risk-weighted assets. (If the Australian
Prudential Regulation Authority believes that a financial institution has a high
risk profile, then it will impose a higher benchmark.) The term 'risk-weighted
assets' needs explanation. Under the capital adequacy regulation, certain types
of loan are considered to be safer or less risky than others; for example, capital
adequacy considers home loans to be less risky than business loans. (Note that
this is a generalisation and the reverse could easily be true in specific situ-
ations.) The risk weight or the capital that needs to be put aside for a housing
loan will therefore be less than that for a business loan for a similar amount.
The Basel Committee of the Bank for International Settlements decides the risk
weight for each type of asset. These recommendations have been mostly
adopted in Australia and elsewhere in the world.
The formula for capital adequacy is:
· k b d . I . _ Total capital(Tier 1 + Tier 2)

RIS - ase capIta rano - R' k d' d .
IS -a Juste assets
Capital is much more than ordinary equity and includes instruments that
perform like equity. Tier 1 capital exhibits permanence like capital, while
tier 2 capital has the ability to absorb credit losses but is not permanent.
Tier 2 capital cannot make up more than 50 per cent of overall allowable
capital. Table 12.1 indicates the various capital classes.
372 Part5: Assessment

andmanagement
of risk I
TABLE 12.1 Various capital classes
Tier1 Tier2 (including

conditions)
Paid-up ordinary shares General provisions for doubtful debts
(limited to 1.5 per cent of total risk assets)
General reserves Asset revaluation reserves
Retained earnings Cumulative irredeemable preference shares
Noncumulative irredeemable preference Mandatory convertible notes
shares
Minority interests in subsidiaries Perpetual subordinated debt
Less Goodwill Redeemable preference shares and term
subordinated debt (minimum original
maturity of at least seven years and
amortisation factor of 20 per cent of original
amount to apply each year during the last five
years to maturity)
The amount of capital that is allocated for each loan depends on the type of
loan and its risk categories, as perceived by the regulators. These risk categories
(a selective list, based generally on loans) are as follows:
• Category 1 (0 per cent weight) - notes and coins; balance with the Reserve
Bank of Australia; Commonwealth Government money market securities
(not exceeding twelve months to maturity)
• Category 2 00 per cent weight) - claims on Commonwealth Government
(greater than twelve months to maturity); claims on State governments
• Category 3 (20 per cent weight) - claims on banks
• Category 4 (50 per cent weight) - loans fully secured by mortgage against
residential property used for rental or occupied hOUSing (based on a
loan-to-value ratio - LVR - of 80 per cent or less)
• Category 4 (100 per cent weight) - loans fully secured by mortgage against
residential property used for rental or occupied housing (based on an LVR of
greater than 80 per cent); commercial companies.
To provide a $100000 home loan with an LVR of 80 per cent or less, the
amount of capital required is:
Capital required = Amount of loan x risk weighting x 8%
= $100000 x 50% x 8%
= $4000.
Example
Consider the statement of financial position of the following financial institution,
XYZ Bank.
Assets $ million Liabilities $ million
Housing loans 75 Deposits 80
Commercial loans 20 funds 15

For this bank, we need to calculate the capital that needs to be put aside for
each loan category. Note that for banks we generally calculate capital adequacy
in categories rather than specific loans.
Housing loans
Risk-weighted asset = Notional amount x Risk weighting
= $75 million x 50%
= $37.5 million
Commercial loans
Risk-weighted asset = Notional amount x risk weighting
= $20 million x 100%
= $20 million
Recall the formula for capital adequacy:
· kb d . 1 .
RIS - ase capIta ratIo = Totalcapital(Tierl+Tier2)
. k d· d
RIS -a Juste assets
$15 million
$20 million + $37.5 million
= 26.1%.
The problem :vith the gUidelines as they are today is that all loans to corpor-
ates are rated at 100 per cent, whether for a company close to default or for a
solid company such as Telstra. This obviously distorts the lending decision
from the approval stage through to the pricing decision. A new capital adequacy
standard is being promulgated, which will differentiate company credit risk
based on companies' credit rating. This will result in a tiered risk-weighting
system for companies, as discussed later in the chapter.
largecreditexposures
An 'exposure' under prudential regulations generally means a potential for loss
under a finance facility that has been provided. In terms of credit exposure,
when an ADI provides a large loan to a business, it exposes itself to that busi-
ness in the event that it defaults. A large exposure means that the capital base of
the AD! is exposed.
The Australian Prudential Regulation Authority regulation for large credit
exposures is found under Prudential Standard APS 221, Large Exposures. This
guideline states the objective as follows:
This standard aims to ensure that locally incorporated ADIs implement prudent
measures and limits to monitor and control risk of concentrations in respect of
large credit exposures to individual counterparties or groups of related counter-
parties on a consolidated group basis.
The obvious issue here is that the Australian Prudential Regulation Authority
feels that large exposures have the potential to affect ADI solvency. The

andmanagement
of risk I
standard states that credit risk exposure increases when spread through only a
small number of lending counterparties.
Under the standard, a large exposure is defined as an exposure to an indi-
vidual or group of counterparties that exceeds 10 per cent of the consolidated
capital base. The capital base is that specified in the capital adequacy guidelines
and includes both tier 1 and tier 2 capital.
Note, however, that it is not illegal to have exposures greater than 10 per
cent as long as the Australian Prudential Regulation Authority is notified. In
these circumstances, the authority may choose to place additional requirements
on an ADI (such as a higher capital adequacy benchmark ratio) to address such
risks.
The Australian Prudential Regulation Authority requires that each ADI report
its large exposures (10 per cent and above) quarterly. This highlights the need
for ADIs to specify correctly the relationships between common counterparties,
to ensure all exposures are recognised.
Securitisation
In chapter 13, we will explain that securitisation is a good credit risk manage-
ment tool in certain circumstances. As with large exposures, however, the
Australian Prudential Regulation Authority imposes some guidelines in allow-
ing securitisation to be effective as a technique. The issues for securitisation
are to be found in the Prudential Standard APS 120, particularly, Guidance
Note AGN 120.3.
Guidance Note 120.3 is expansive and we cannot canvass all issues in this
section. It works around the concept of a clean sale, which:
• absolves the financial institution from any legal recourse from the sale of loans
• results in the financial institution not holding capital against the loan.
The above can be likened to the sale of a motor vehicle. Once the sale has
been effected, the seller is not liable for any defects or accidents. If, however,
there is an obligation held by the securitising financial institution, then the
Australian Prudential Regulation Authority will deem that the credit risk
remains with the financial institution. How the obligations are removed is sum-
marised in the following sections.
Cleansalesupplyofassets
This section of the prudential note deals with the sale of loans that are not
revolving, such as home loans. The following rules govern a clean sale:
• There should be no beneficial interest in the sold assets and absolutely no
obligation to the financial institution.
• There should be no recourse (including costs) to the lending institution. In
addition, there should be no obligation for the lending institution to
re-purchase the lending assets.
• The amount paid for the loans should be fixed and should be received by the
time the assets are transferred from the lending institution.
• Any assets that are provided to the special-purpose vehicle as a substitute or
provided at below book value are not considered as relieving credit risk.
The above gUidelines have not had the benefit of substantial testing and the
concern is not about legal recourse; rather, the concern is about moral recourse.
The selling of financial assets is always subject to the problems of asymmetric
information where the seller knows more about the loan than the buyer. There
is a concern that in the event of economic downturn, when defaults become
more frequent, sellers of assets may be under a moral obligation to re-purchase
assets. The moral obligation occurs because there might have been something
defective about the loan that was not obvious at the time. Under these circum-
stances, the financial institution would have been carrying the implicit credit
risk.
Revolving
facilities
Credit card receivables are the most common revolving facility that has been
securitised. The conditions for a clean sale of these assets are different, given
that the lending assets can have redraw facilities attached to them.
The following is a summary of conditions:
• The rights, details and obligations of each party must be clearly specified,
including the distr.ibution of cashflows.
• As with normal asset securitisation, the financial institution cannot supply
additional assets to the pool.
• Liquidity shortfalls for the financial institution share must not exceed the
interest receivable.
• The financial institution always has the right to cancel any undrawn amounts
on the revolving facilities.
• Again, like normal lending securitisation, the financial institution must be
under no obligation to re-purchase assets that have defaulted.
Creditderivatives
Chapter 11 discussed the innovation of credit derivatives, which had the ability
to dramatically alter the credit profile of the statement of financial position of a
financial institution. Given the infancy of the credit derivatives market, how-
ever, the Australian Prudential Regulation Authority acknowledges the benefits
of these instruments but has imposed conservative gUidelines.
The guidelines for credit derivatives are divided into Guidance Note AGN
112.4, which deals with credit derivatives in the banking book, and Guidance
Note AGN 113.4, which deals with credit derivatives in the trading book. We
are dealing with the management of credit risk (that is, the management of an
underlying loan), so our focus here will be on the former guideline. For the
purposes of the discussion, we will also assume that the financial institution is
a protection buyer (that is, it is protecting a credit position). This does not
negate that the possibility that a protection seller is assuming a credit position
for the purposes of managing the concentration risk of a portfolio.

andmanagement
We have already addressed large exposure issues in a previous section. Note
that large exposures include credit derivative transactions. The guidance note,
however, is not clear as to whether large exposures include those credit deriva-
tives that result in the acquisition of credit risk or all credit derivatives. Given
the current conservative stance taken by the Australian Prudential Regulation
Authority, it may be monitoring the market as a whole.
The effectiveness of credit derivatives becomes an issue of how well the instru-
ment reduces the requirement of capital adequacy. Although a credit derivative
may reduce the overall credit exposure, its effectiveness may be reduced if capital
relief is not forthcoming. The Australian Prudential Regulation Authority will
only provide regulatory capital relief if, for example, it is satisfied that the set of
credit events is not restrictive and allows the transfer of sufficient risk.
It is important, therefore, that it is made clear that the credit events clearly
and unambiguously transfer credit risk to the protection seller. The Australian
Prudential Regulation Authority has noted that it expects one of the credit
events to be bankruptcy to allow capital relief. Further, note that some materi-
ality thresholds (an amount that is lost before the credit event is triggered) may
disallow relief.
The final issue in the regulatory treatment of credit derivatives is that of mis-
matches, which are discussed in terms of asset mismatches and maturity mis-
matches. A credit derivative is deemed to afford protection if the phYSical
settlement has a deliverable obligation. If the settlement is in cash, however,
then the following requirements must be met for capital recognition:
• The underlying and reference assets are the same.
• The underlying asset is an obligation under the terms of the contract. An
obligation is defined as a financial obligation.
• The reference asset ranks lower than the underlying asset.
In terms of maturity, a financial institution is deemed to have full protection
if the maturity of derivative equals the maturity of the underlying asset. If the
maturity of the derivative is shorter than the underlying asset, then the residual
term of the underlying asset does not count for capital adequacy. If, for
example, a loan has a term of five years and the credit derivative has a maturity
of four years, then only 80 per cent of the exposure is counted for regulatory
relief.
Other issues such as currency mismatches and in-built options on credit
derivatives are outside the scope of this chapter. For those interested, see the
guidance note for discussion.
Developments
in regulation
As mentioned earlier in the chapter, capital adequacy is the primary tool for the
Australian Prudential Regulation Authority to regulate credit risk issues. The
current arrangements, however, distort the lending decision because all cor-
porate credit risk is rated 100 per cent regardless of the company involved.
A new proposal (under promulgation) would base the risk weighting on the
credit rating of the company. The interesting part of this proposal is the use of
a nongovernment organisation (the credit rating agency) as part of the regu-
lation process. This raises the issue of independence because ratings are
assigned when paid for by debt issuers.
Before discussing these proposed changes, it is important to understand the
credit rating process. Many organisations, both financial and nonfinancial, do
not have the resources to carry out credit analysis. These organisations would
normally use credit ratings as the replacement for their own analysis.
Creditratings
The credit rating agency discussed here is Standard &: Poor's, which is a private
company owned by the McGraw publishing group. Its main business is to rate
debt issues or actual borrowers. In defining its rating objectives, Standard &:
Poor's (2000) state that 'A credit rating is Standard &: Poor's opinion of the
general creditworthiness of an obligor, or the creditworthiness of an obligor
with respect to a particular debt security or other financial obligation, based on
relevant risk factors'.
The ratings are generally divided into two types: short term and long term.
There are other types but they are beyond the scope of this chapter. The defi-
nitions of these ratings are found in table 12.2.
TABLE 12.2 Standard & Poor's credit ratings
I Rating Description
Long term
AAA This is the highest rating. The obligors capacity to meet its financial commitment on the
obligation is extremely strong.
AA An obligation rated AAdiffers from the highest rated obligations only to a small degree. The
obligor's capacity to meet its financial commitment on the obligation is very strong.
A An obligation rated A is somewhat more susceptible to the adverse effects of changes in

circumstances and economic conditions than obligations in higher rated categories. The
obligors capacity to meet its financial commitment is still strong, however.
BBB An obligation rated BBBexhibits adequate protection parameters. Adverse economic

conditions or changing circumstances, however, are more likely to lead to a weakened
capacity of the obligor to meet its financial commitment on the obligation.
BB* An obligation rated BBis less vulnerable to nonpayment than other speculative issues, but it
faces major ongoing uncertainties or exposure to adverse business, financial or economic
conditions that could lead to the obligor's inadequate capacity to meet its financial
commitment on the obligation.
B An obligation rated B is more vulnerable to nonpayment than obligations rated BB,but the
obligor currently has the capacity to meet its financial commitment on the obligation.
Adverse business, financial or economic conditions will likely impair the obligor'scapacity
or willingness to meet its financial commitment on the obligation.

Rating Description
C Long term (continued)
ccc An obligation rated CCC is currently vulnerable to nonpayment, and depends on favourable
business, financial and economic conditions for the obligor to meet its financial
commitment on the obligation. In the event of adverse business, financial or economic
conditions, the obligor is not likely to have the capacity to meet its financial commitment
on the obligation.
cc An obligation of CC is currently highly vulnerable to nonpayment.
c The C rating may be used to cover a situation where a bankruptcy petition has been taken
but payments on this obligation are being continued.
D The D rating, unlike other ratings, is not prospective; rather, it is used only when a default
has occurred.
Short term
A-I The short-term obligation of A-I is rated in the highest category by Standard &: Poor's. The
obligor's capacity to meet its financial commitment on the obligation is strong.
A-2 A short-term obligation of A-2 is somewhat more susceptible to the adverse effects of
changes in circumstances and economic conditions than obligations in higher categories.
The obligor's capacity to meet its financial commitment on the obligation is satisfactory,
however.
A-3 A short-term obligation of A-3 exhibits adequate protection parameters, but adverse
economic conditions or changing circumstances are more likely to lead to a weakened
capacity to meet its financial commitment on the obligation.
B A short-term obligation of B is regarded as having significant speculative characteristics. The

obligor currently has the capacity to meet its financial commitment on the obligation, but it
faces major ongoing uncertainties that could lead to the obligor's inadequate capacity to
meet its financial commitment on the obligation.
c A short-term obligation of C is currently vulnerable to nonpayment and depends on

favourable business, financial and economic conditions for the obligor to meet its financial
commitment on the obligation.
D See the definition of D under the long term ratings.
* This credit rating starts what is known as speculative grades.

Note: Plus and minus signs are used to modify the ratings AA to CCC to indicate relative standing in the rating category.
Source: Adapted from Standard & Poor's 2000, 2000 Corporate Ratings Criteria, www.standardandpoors.com.
accessed 15 July 2002. © by Standard & Poor's, a Divisionof The McGraw-HiliCompanies, Inc. Reproduced with
permission of Standard & Poor's.
If credit ratings are to be the basis of alteration to capital adequacy, then it is

important to understand the rating process. The process starts with a meeting
with the company under consideration, to help the company know what to
expect and what will be required of the rating process. The corporate credit risk
factors are divided into two: business risk and financial risk. Both risks are fur-
ther divided, as we will consider in the following sections.
Business
risk
When measuring the business risk of a company, a credit rating agency will
evaluate the following factors.
Industrycharacteristics
An assessment is made of the prospects and risks attached to the industry in
which the business operates. This process will also indicate the cap of ratings
for the business within the industry. The riskier the industry, the lower is the
cap. Issues that would be addressed include:
• key rating factors for that industry, such as profitability factors and risk
vulnerability
• diversification factors for businesses that have exposures to different industries
• size, and geographic and market dominance.
Management
evaluation
The management of the business will be assessed for their ability to plan and
implement their business plan. An opinion is formed of management's appetite for
risk, and the inclusion of past business successes would be considered. There is also
a focus on the structure of the organisation and any undue reliance on one person.
Industry-specific
factors
For many industries, Standard & Poor's will provide specific factors that it will
consider. The is a summary of these considerations:
• industry regulations
• markets
• operations (revenue and costs)
• competitiveness.
Financialrisk
The following factors are considerations when measuring financial risk:
• Accounting quality. Given that the qualitative assessment of the business is
based on the audited accounts, financial reporting quality starts as a base.
• Financial policy. An assessment of the firm's financial policy depends on
whether such a policy exists, how it is used, how it assesses risk and how it
proposes risk mitigation.
• Profitability and coverage. Given that earnings and cashflow repay debt, this
issue is very important in Standard & Poor's analysis. Some measures that are
examined are:
pre-tax pre-interest return on capital
- operating income as a percentage of sales
- earnings on business segments assets.
A number of issues are also examined in this area, including:
trends
- an analysis of historical trends and the reconciliation to projected earnings
- earnings in relation to fixed charges.
A number of adjustments are made to ensure accounting issues do not cloud
the earnings power of the business.

• Capital structure/leverage and asset protection. The following ratios are
considered by Standard 6;[ Poor's:
total debt divided by (total debt plus equity)
(total debt plus liabilities off the statement of financial position) divided
by (total debt plus liabilities off the statement of financial position plus
equity)
total debt divided by (total debt plus market value of equity).
• Asset valuation. In terms of capital structure, the value of the business's assets
can make a material difference to viability.
• Financing off the statement of financial position. Standard 6;[ Poor's factor the
following into leverage considerations:
operating leases
debt of joint ventures and unconsolidated subsidiaries
guarantees
take or pay contracts and obligations under throughput and defiCiency
agreements
receivables that have been factored, transferred and securitised
contingent liabilities.
• Preferred stock. The characteristics of the preference shares are examined to
ascertain whether they exhibit the features of debt or equity. Redeemable
preference shares, for example, would be considered to be debt.
• Cashjlow adequacy and ratios. Cashflow, not accounting earnings, is what
repays debt. It is the most critical factor in Standard 6;[ Poor's assessment.
The ratios used are:
funds from operations divided by total debt
earnings before interest, tax and depreciation divided by interest
(free operating cashflow plus interest) divided by interest
(free operating cashflow plus interest) divided by (interest plus annual
principal repayment obligation)
total debt divided by discretionary cashflow
funds from operations divided by capital spending requirements
capital expenditure divided by capital maintenance.
• The need for capital. Standard 6;[ Poor's examine a business's requirements for
equity and working capital, relati.ve to its capital works needs.
• Financial jlexibility. Standard 6;[ Poor's examine issues such as overreliance on
anyone finance source.
Much more could be added to the above, but these are the major issues that
are considered in the rating process. If you are interested in more details, the
full process is available on the Internet (www.standardandpoors.com).
How Standard 6;[ Poor's combine the above analysis is a trade secret. All that
is publicly known is the set of elements that are considered in rating an issuer
or obligation. Knowing these elements, we can move onto the new capital
adequacy proposals.
Introduction
For most of this book, our focus has been on the assessment and approval of
loans. Lending is clearly a risky activity, however, and lending institutions
occasionally grant loans that incur a loss. The loss may occur as a result of
many factors, from poor management of the borrower to the timing of the busi-
ness cycle.
The primary issue of problem loans is that they can impair the value of a finan-
cial institution. Too many impaired loans on the statement of financial position
of a lending institution may threaten its solvency. It is expected that some loans
will become problem, but the aim of a financial institution is to manage the
problem in such a way as to reduce the loss of value to shareholders. The first
course of action, therefore, is not to foreclose, but to manage the asset or firm.
Causesofdefault
A default is defined here as a loan for which the repayments are overdue.
Lending institutions may experience defaults and problem loans for the
following reasons (Golin 200 I):
• lack of compliance with loan policies
• lack of clear standards and excessively lax loan terms
• inadequate controls over loan officers
• overconcentration of bank lending
• loan growth in excess of the bank's ability to manage
• inadequate systems for identifying loan problems
• insufficient knowledge about customers' finance
• lending outside the market with which the bank is familiar.
All these reasons for default are found within a lending institution. Many
problem loans could be avoided by better lending procedures and policies.
Credit risk is never static, however, and many loans that were validly granted
can become bad for many different reasons. Two examples are when a recession
affects firms that rely on cashflow or when firms wind up because their prod-
ucts have become outdated. The issue then becomes how best to monitor these
situations. Monitoring is easier said than done.
While it may be easy to monitor a small portfolio of loans, the situation
becomes more complex as the financial institution becomes larger. This com-
plexity introduces higher and higher costs for monitoring. To ensure efficiency,
indicators (such as consecutive missed payments) are normally implemented.
These indicators are normally 'noisy', however, which means that they do not
present a clear picture of the situation or indicate remedial action. In many
cases, these indicators highlight a problem loan when it is too late, resulting in
a less than optimal situation for the lending institution.
In chapter 11, we noted that one function of default models is that they can
provide early warnings of developing problem loans. This can be helpful for
monitoring purposes.

andmanagement
of risk I
Theextentofproblemloans
Table 13.1 shows the experience of banks since 1994 with the value of
impaired assets (bad loans) they are managing. From highs in the early 1990s,
the value of impaired assets drops quickly. In more recent months, however, the
level of impaired assets has perceptively risen. This may show the results of the
business cycle and give us some clues for managing the situation.
TABLE 13.1 Global consolidated group impaired assets
Non-accrualitems Restructureitems Other Other Total

With Without With Without real estate assets impaired
Atendof: provisions provisions provisions provisions owned acquired assets
September 1994 10383 2715 134 605 247 56 14140
December 1994 8846 2614 131 609 255 49 12503
March 1995 8362 2570 156 541 119 46 ll794
June 1995 7710 2487 164 450 143 47 11002
September 1995 6754 2200 122 429 138 41 9684
December 1995 6234 2014 141 224 140 92 8845
March 1996 5762 2014 121 176 135 88 8298
June 1996 5205 1933 109 169 133 50 7598
..September 1996 4583 1628 109 145 119 47 6631
December 1996 4248 1507 115 169 115 32 6185
"."
March 1997 3995 1486 123 149 llO 30 5893
June 1997 3743 1387 124 129 39 10 5432
September 1997 3520 1323 III 69 32 11 5066
December 1997 3286 1268 91 96 30 20 4790
March 1998 3815 1395 98 85 28 21 5442
June 1998 4179 1732 72 80 28 14 6105
September 1998 4190 1649 70 74 17 12 6012
December 1998 4134 1520 49 68 26 20 5818
March 1999 4134 1411 23 65 24 14 5672
June 1999 4029 1509 20 62 56 15 5691
September 1999 3881 1619 27 58 48 22 5654
December 1999 3993 1510 54 54 34 31 5675
March 2000 3937 1697 49 53 35 50 5821
June 2000 3972 1350 48 41 33 68 5513
September 2000 3733 1707 74 85 36 65 5701
December 2000 3526 1602 68 92 24 61 5374
March 2001 4163 2306 65 74 24 76 6707
June 2001 4085 1678 70 59 10 46 5948
September 200l 4611 3026 64 33 9 49 7791
December 2001 5342 2045 112 37 10 27 7572
March 2002 5354 2005 61 21 10 27 7477
June 2002 5008 1938 17 21 14 26 7025
Source: Reserve Bank of Australia 2001, Table B05: Banks - global consolidated group impaired assets,
WWw.rba.gov.au/statistics/Bulietin/B05hist.xls, accessed October 2002.
The previous table indicates that impaired loans fell from a high in 1994 to
what is considered normal in late 1997. The explanation is that the economy
went through a recession in the early 1990s, only to recover through the rest of
that decade.
Lenders also need to recognise the potential for some loans to default and build
this potential into loan pricing. It is equally important for lenders to recognise
that loans that default have a corresponding impact on the profitability of the
institution and, ultimately, this loss is borne by the shareholder. This scenario is
exemplified by the Commonwealth Bank's share price experience following sev-
erallarge potential losses, as shown in the following 'Industry insight' .
. Pasminco has total lia-

and SSB believes the asset sale
erne'. , $1 billion.
ij:fjJ1:J,{l,
c ..•."
$1.8 billion defreh;and Pasminco's remaining sme1 tef·
of sustaining this level of liabilities', the brokef",
the ongoing viability of the company, there would

a part of forgiveness of the loans outstanding'.
the perils of lending to the dot corns, unlike
However, it does not mean they are immune to
).
The Commonwealth Bank's share price came under pressure reportedly as a

result of its exposure to Pasminco. Pasminco was a miner and smelter, with its
major product being zinc and its byproducts. Dubious risk management poli-
cies meant that the company experienced financial problems when the price of
zinc collapsed. This is an example of economic conditions playing a part in
defaulting loans. The lack of bank monitoring could also have had an influence
in the situation. The company was eventually placed into receivership under
the weight of $2.8 billion. The Commonwealth Bank had the largest exposure
to the firm: $400 million, of which the market believed that $200 million would
have to go to bad debts. The above 'Industry insight' highlights the damage to a
lender that large-scale problem loans can cause, with the Commonwealth Bank
share price suffering at the time. These losses have an impact on the share-
holders and the share price. The banks thus are not immune to bad debts.

andmanagement
In this chapter, we will investigate some important concepts regarding how
lenders should manage their problem loans:
• What are the various types of problem loan? How do we define them?
• How do lenders manage the impact of problem loans on profitability? Can
they anticipate problem loans?
• Is there a pattern of when problem loans occur?
• Is a grading attached to the severity of the problem loan and how it is
managed?
• What are the legal implications for managing problem loans?
Making this issue more difficult, most financial institutions handle it in a
different way. The issue is nevertheless the same and a lender should
manage the economic worth of the loan relative to the economic worth of
the borrowing company. It is far too easy to say that the appropriate action
for a bad loan is liquidation. liquidation simply means selling the bor-
rower's assets. This is a hasty response because the success of the liquidation
depends on the type of collateral, which will have a fire sale value. In some
instances, the asset offered as collateral is unique and will have no natural
market.
Finally, while problem loans inevitably occur, there has been an observable
pattern to their increase and decrease in regularity. This pattern may not con-
tinue, however, because financial institutions are using advanced management
techniques, such as dynamic provisioning, to smooth out the spikes of problem
loans. Dynamic provisioning is a statistical method that seeks to forecast
doubtful debts and spread them over a number of years. These spikes can be
predicted by the business cycles.
Thebusiness
cycle
A bank's experience with problem loans can normally be tracked by examining
the business cycle. Dynamic provisioning (which we will discuss later) uses the
business cycle as its foundation, although this could disguise the actual
problem loan experience. It is useful, therefore, to consider the characteristics
of the business cycle results in the problem loan experience.
Recovery
andexpansion
During this period, confidence in the economy flourishes and new investment
increases. Increased consumer confidence leads to increased spending, which
normally finds its way into bank deposits. This gives banks an overall increase
in money supply. With this increased liquidity, banks look for more oppor-
tunities to lend. Unfortunately, this impetus often leads to the relaxation of
lending standards. While interest rates also increase at this time, they tend to be
relatively low. This exacerbates the situation because it encourages marginal
investments by individuals and business, as well as poor lending strategies by
lending institutions.
Boom
This period of the business cycle is exemplified by asset inflation. Much invest-
ment goes into real assets such as real estate, with much borrowing against
these assets. The other characteristic of this part of the cycle is overconfidence,
which may lead to declining credit standards. While interest rates are probably
rising, this rise still does not dampen economic activity.
Downturn
While it is not easy to explain, the confidence in economic activity reaches a
peak and then enters a downturn. While a book can be written on the eco-
nomics of this situation, one characteristic of this section of the cycle is that
asset prices decline. The decline of asset prices leads to less spending and, ulti-
mately, declining cashflow for many businesses. Where there have been lax
credit standards, loans approved under those standards no longer perform
because they were written during more optimistic times. Banks experience their
greatest problem loans at this time, because many loans were written against
asset valuations that are now worth much less. The marginal investment oppor-
tunities taken during more optimistic times become losses for both investors
and lending institutions.
Problem
loans,provisions
andregulatory
issues
When a borrower misses a repayment on a loan, a number of questions are trig-
gered within the lending institution. The first question is whether the missed
payment is a temporary situation or one that threatens to be permanent. If the
situation is temporary, then the lending institution will manage it differently
than a more permanent situation.
Internationally, if the situation persists for longer than ninety days, then the
loan is defined as an impaired asset or nonperforming loan. This is also the
situation in Australia. It is called 'impaired' because the lending institution is
not receiving full return on the loan and, therefore, the loan is not fully
valued on the financial institution's statement of financial position. Even if a
loan is partly repaid under these circumstances, then it becomes impaired;
that is, a full repayment does not need to be missed for an asset to be
declared impaired. Given that the financial institution has funded the loan,
any portion of the loan not repaid in a timely fashion will result in the loan
being declared impaired, because it has the potential to create negative
income. The position of the loan in the institution's statement of financial
position and income statement will depend on the likelihood of the loan
being repaid and the time for which it has been impaired.
For regulatory purposes, the Australian Prudential Regulation Authority con-
siders that if a borrower has multiple facilities and one of those facilities
becomes impaired, then all facilities should be classified as impaired. The level
of impairment is generally seen to be the face value of the facility less the
I 394 Pari5: Assessmentandmanagementof risk I

market value of any security. There are also guidelines on the valuing of
security (as discussed in chapter 12).
When a lending institution recognises a problem loan, it needs to raise pro-
visions. A provision is recognition that income may not be received on a loan.
It is therefore charged against income and is a liability on the statement of
financial position. When it is charged against income, it is not tax deductible; it
becomes an expense when fully written off the statement of financial position.
It becomes a buffer for the bad debt experience.
Lending institutions raise three types of provision when loans become
impaired:
1. specific provisions
2. general provisions
3. bad debt write-offs.
The first two provisions are written off against income, while the third is a
write-off on the statement of financial position, recognising that the loan has
finally become completely irrecoverable.
The Australian Prudential Regulation Authority also prescribes actions for
these provisions (and, in some cases, uses different definitions). These pro-
visions are addressed in the industry standards. A good accounting text will
address the accounting issues.
Specific
provisions
Specific provisions are attached to loans or impaired assets of which a lender is
aware. The lender examines the condition of the loan and considers the econ-
omic situation of the borrower, the enforceability of guarantees ancIJor the cur-
rent value of security when determining the specific provision (Australian
Prudential Regulation Authority 2000).
The specific provision does not necessarily reflect the full value of the loan
because the lender may have specific information that leads it to reasonably
believe that some of the debt is recoverable. This would include certain
recoveries on collateral or recovery of the firm.
Generalprovisions
General provisions are like specific provisions, but they are not charged against
a particular loan. They may occur for a number of reasons. First are the regula-
tory reasons. The Australian Prudential Regulation Authority (2000) views that
0.5 per cent of total risk-weighted credit risk-weighted assets should be used as
a benchmark for general provisioning. This benchmark appears to be a
minimum and the authority could increase it for individual institutions if war-
ranted. Normally, it would be expected that this benchmark would apply if the
Australian Prudential Regulation Authority determined that the lending insti-
tution's portfolio was particularly risky. This approach would penalise those
organisations with conservative lending practices and a historical experience of
low loan loss, because the general provision would be higher than what would
have been charged. The result is that the income charged is not available for
dividends or retained earnings.
The second reason to create a general provision is where the size of loans is
small and specific provisioning would be an administrative burden. An example
is a bank's home loan portfolio, which would be large in terms of the number of
loans being managed. Rather than create specific provisions for a large number
of loans that may default, one provision is created against all problem loans. It
is important to recognise that the term 'large' refers to the number of loans being
considered, not the debt exposure relative to the portfolio size. Large problem
loan exposures should be listed separately. This type of provision is generally
estimated from historical experience.
Finally, a financial institution may raise a general provision when a debt is in
the initial stages of being declared impaired but the institution has not had
adequate time to examine the condition of the borrower. In these circum-
stances, once the condition of the borrower has been examined and all circum-
stances have been recognised, the provlslOn should be moved from general
provisions to specific provisions.
Baddebtwrite-offs
After a period of time, a financial institution needs to recognise that a debt is no
longer recoverable - a bad debt write-off. In other words, all security has been
liquidated, guarantees have been enforced and other remedial actions have been
taken; there are no other sources of cash on which to call. Financial institutions
recognise this point by writing off the asset completely.
Regulatory
issues
Other regulatory issues can be discussed and the following is simply a brief
summary of the prescribed provisioning required by the Australian Prudential
Regulation Authority. (Students desiring details should obtain Guidance Notes
AGN 220.1, 220.2 and 220.3 - see www.apra.gov.au.)
The following are the four categories of provisioning for which lending insti-
tutions need to provide:
• Category 1. This category includes registered first and second mortgages,
where acceptable mortgage insurance is in place that results in the valuation
of a debt-equity ratio of no more than 80 per cent. No provision is required.
• Category 2. This category is the same as category one, except the debt-equity
ratio is 80-100 per cent. The provisioning is given in table 13.2.
• Category 3. This category caters for facilities that do not apply to any of the
other three categories. The debt-equity ratio is greater than 100 per cent:
that is, the debt is worth more than the underlying asset. Table 13.3 gives the
provisioning.
• Category 4. This category relates to overdrawn revolving-type facilities. Table
13.4 indicates the provisioning.

andmanagement
of risk I
TABLE 13.2 Provisioningrequired for category 2 loans
Term01paymentin arrears' Amount01provision(%)
Up to 90 days 0
90 days to less than 182 days 5
365 days and over 20
*The dollar value of contractual payments in arrears for a given period of time -
see Guidance Note AGN 220.3.
Term01paymentin arrears' Amount01provision(%)
Up to 90 days o
*The dollar value of contractual payments in arrears for a given period of time -
see Guidance Note AGN 220.3.
Period01irregularity' Amount01provision(%)
Up to 14 days o
*The number of days for which the overdrawn facility is outstanding.
Otherconsiderations
withproblemloans
We have been considering the regulatory and accounting definitions for the
classification of problem loans. It is worth recognising that many banks have
internal classifications for provisioning purposes, apart from any statistical pur-
poses. One may question why lenders come up with their own schemes as well
as the ones reqUired by the profession and regulators.
Lenders allocate capital against loans, so apart from the normal capital
adequacy guidelines, problem loans are going to affect the efficient use of
capital, particularly because they are not generating optimal income. Many
lenders will therefore seek to redefine provisioning to align with their capital
policy. The internal policy will reflect the risk appetite of the lender. I f the
internal policy results in greater than required provisions, then the lender could
be argued to have a conservative risk profile, while the opposite would rep-
resent a higher appetite for risk.
Chapter 11 highlighted that lending institutions often allocate capital to
lending using, apart from capital adequacy, the risk-adjusted return on capital
(RAROC) or the CreditMetrics™ method. Considering these methods, we
could conclude that:
• a loan that has become impaired would fail the RAROC hurdle rate
• CreditMetrics™ should provide a higher capital allocation amount.
Dynamic
provisioning
Reviewing table 13.1 again, holding impaired assets on the statement of financial
position does not generate income. It is true that bad debts occur at the lowest
point of the business cycle, which is when financial institutions' profit statements
are particularly vulnerable. What this situation shows, however, is that credit will
deteriorate over time until some loans default. In other words, lenders need to
recognise that:
l. credit risk is not static, but changes over time
2. bad debts should not come as a surprise.
While loans are costly to monitor, models examined in earlier chapters, if
properly used, should highlight any loans becoming problematic. Financial
institutions nevertheless should be looking at methods that smooth the bad
debt experience and charge doubtful debts against income over time rather than
at the bottom of the economic cycle. The process should lead - rather than lag
- the bad debt· experience. This approach will minimise income volatility that
occurs as a result of problem loans. The process is known as dynamic provi-
sioning.
While banks are reluctant to disclose how they carry out dynamic provi-
sioning, a number of principles are known:
• Classify the loans in the portfolio into homogenous groups. This means that
the loans should be of the same type and exhibit the same risk profiles. 'No
frill' home loans, for example, should not be included in the normal standard
home loan product group.
• The different types of loan should be further broken down into groupings by
maturity. This split recognises that loans carrying longer maturities have a
greater propensity to default.
• Once this classification is complete, two statistics can be generated:
- the probability of default for each loan class
- the likely severity of loss.
• The multiplication of these prior statistics determines the historical loan loss
ratios.
• Historical loan loss ratios are then transformed (by the adjustment for
economic circumstances) to be predicative. The economic circumstances
could range to the level of interest rates through to inflation rates and the
level of investment activity. As mentioned previously, most loan defaults
occur at the bottom of the economic cycle and the principle is to apply the
characteristics of the economic cycle to the loan portfolio.

andmanagement
of risk I
• The transformed loan loss ratio is then applied to the current loan portfolio
to determine provisions. Loans that can be recognised as becoming impaired
in future years can therefore have provisions applied against income in better
economic times.
A number of issues need to be kept in mind when considering dynamiC pro-
visioning. First, the quality of the data needs to be good. Banks using long his-
tories should be able to use these principles accurately to good effect. While
banks' estimates should be relatively stable, however, re-estimation is also
i.mportant to ensure any structural change to any industry is incorporated. The
introduction of capital adequacy, for example, altered the way in which banks
provided loans; Similarly, the introduction of new capital adequacy guidelines
would have the capacity to alter the way banks assess loans.
The second issue is one that is always important when historical data are
used to forecast future events. It is an area of finance that always creates debate.
In loan provisioning, given the constant tide of structural change, the question
needs to be asked whether using historical data is the correct way in which to
calculate provisions. Further, against which benchmark are we measuring the
performance of such models?
The above discussion highlights the point that banks are not transparent
about their loan loss experience. Banks do not want to damage their reputation
by admitting excessive bad debt experiences. Methods such as dynamic provi-
sioning, however, may not give the analyst the confidence reqUired to assess
proper levels of provisioning, apart from those required by regulators.
Dealingwithdefaults
Having discussed definitions, regulatory requirements and financial institution
practice, we are now in a position to examine the processes to undertake when
identifying a problem loan.
Lending institutions are most reluctant to discuss their experiences and prac-
tices in this area, so here we will identify three types of potential default situ-
ation and develop principles for dealing with these situations. The three
situations are:
1. mild financial distress
2. moderate financial distress
3. severe financial distress.
In dealing with these categories, keep in mind that some problem loans can
be difficult to categorise and may display characteristics of more than one situ-
ation. Two principles always apply, however, in dealing with these loans:
1. The primary aim of the bank is to minimise the loss to the bank. In many
circumstances, this will mean not liqUidating the loan because the collateral
will be worth only fire sale value.
2. To manage these problems correctly, the economic worth of the loan is
compared with the economic worth of the borrower.
We will discuss the three types of financial distress and then complete this
section with some comments on the coordination problem loans where mul-
tiple lenders and priorities are involved.
Mildfinancialdistress
Mild financial distress occurs when companies experience temporary cashflow
shortages. In most cases, this type of distress never enters the public arena and
is not captured by the regulator'S definitions. As long as the loan does not stay
in arrears for longer than ninety days, this type of situation is opaque to the
general community.
In many instances, the cashflow shortages are temporary and may be rectified
within days. A major receipt might have been delayed, for example. The
shortage is sometimes more lasting and more serious remedial action needs to
be considered.
The overall condition of a company experiencing mild financial distress is
that its economic worth is of higher value than the repayment schedule of the
loan. In other words, creating a situation of default could rapidly depreciate the
value of the firm's assets, causing both the borrower and lender to lose money
- a situation to avoid.
A number of remedies can be used in this instance. The simplest approach is
for the bank to agree to an extension on the repayment, in recognition of the
temporary nature of the situation. In most instances, the bank would charge
penalties to ensure there are disincentives to prevent the situation arising again.
A review should be undertaken to ensure all potential revenues are being
exploited and costs are under control. The default of the telephone company
One.Tel in 2001 was partly due to the failure of its billing systems to bill its
clients properly and identify those customers requiring further action. Some
One. Tel customers had accounts that were overdue by more than three hundred
days. In other words, expected cashflow did not materialise.
Note, however, that banks should take further reviews or actions to ensure
that their position is protected. Remembering that cashflow repays the loan, a
lender should take steps to protect the cashflow of the borrower. The following
suggestions are not exhaustive and critical review skills should be used when
examining each situation.
The most common cause of cashflow shortages in firms is overly rapid
growth of the firm. As firms grow, they need more investment in productive
capital, whether computers, plant or land. While this investment is undertaken,
revenue normally does not keep pace until the growth stage is complete. The
solution may be to delay the investment until the temporary cash shortage has
disappeared, because there may be a logical milestone in the expansion where
cashflows reach a necessary level. In other words, the maturity of the develop-
ment is so finite that it is worthwhile accepting the temporary repayment of
loan facilities.
In some instances, borrowers may hold assets that perform poorly. In many
cases, these assets are not core to the borrower and were acquired either

through acquisition of another firm or where diversification of firms in a group
was seen as a positive step. In any event, selling noncore assets, particularly if
they are poor performers that degrade overall performance, can generate valu-
able cashflow.
The final suggested solution is a simple one. Where lending can be a matter
of transferring risk to the appropriate party, mild financial distress may be a
matter of requiring the shareholder to supply more equity to the business. In
other words, it may not be appropriate for the lender to make any concessions.
Moderatefinancialdistress
As mentioned previously, the difference between the various levels of distress is
one of degrees. In the case of moderate financial distress, a temporary cashflow
shortage again is evident, but the economic worth of the company is less than
the repayment schedule of the loan. If the bank were to wind up the borrower,
then it would generate a loss in the process. This loss would depend on the
value of any offered collateral. A registered residential first mortgage would
have little negative effect on the value of its collateral (the home), while a
manufacturing firm in default may find its economic worth rapidly degrades in
the absence of a buyer of its assets, particularly if the assets are unique. The
lender should simply liquidate the registered residential first mortgage but exer-
cise more care in the latter case. It may be more beneficial for the lender to
restructure the loan.
As a simple example, Little Company owes Big Bank $300. The owner of
Little Company has some speCial skills to run the firm for $15. These special
skills result in the firm being worth $315 with a probability of 0.8, otherwise
zero. We will use these values to calculate the expected value of the firm. (Addi-
tional information on the calculation of expected values can be obtained from
any good business or corporate finance textbook.) The liquidation value of the
firm is $200.
Before going through the options available, it is important to point out that
the Little Company's owner's special skills align with the fact that liquidating
the firm would cause the assets of the firm to depreciate in the absence of a
buyer. This is the same as saying that the assets are unique. In this example,
there are two options.
The first option is to liquidate. This is the appropriate strategy for Little
Company because its expected value (or net present value) is negative, as
follows:
0.8(315 - 300) + 0.2(0) - 15 = -3.
What this tells us is that Little Company's pay-off will be $315, with a prob-
ability of 0.8 in the good state. The firm needs, however, to make a repayment
of $300. It receives nothing in the bad state and spends (exerts) $15 worth of
energy to produce. Its expected value is zero, so it would prefer to liquidate and
receive nothing. Big Bank would receive $200 - a loss of $100 - in liqui-
dation, which is the difference between the loan amount and liquidation value.
The second option is to restructure the loan to give the owner the incentive
to continue. This restructure is determined by calculating the break-even
amount of the loan, which we will call x - that is, the circumstances under
which Little Company would continue:
0.8(315 - x) + 0.2(0) - 15 = o.
The above formulation is the same as for the first option, except we are
solving for x when the expected pay-out is zero (the minimum that Little Com-
pany will accept). We find that x, or the break-even loan amount, is $296.25.
A loan of $296.25 would be better than liquidation value of $200 and the
owner of Little Company would have the incentive to continue. Note that Little
Company would continue the gain as the value of the loan falls. In these cir-
cumstances, the bank loses $3.75 rather than $100.
Severefinancialdistress
This financial distress is the most obvious of all. It normally finds its way into
the provisions for doubtful debts of a bank. Under this scenario, severe financial
distress is characterised by a missed debt payment as well as the borrower
having an economic worth less than the repayment schedule. The normal
course of action is to wind up the firm, but this may not always be the best
course of action. A number of issues need to be considered.
The first issue is whether the borrower has a sound business. Is the default
due to reasons other than the nature of the business? When Fairfax Limited
defaulted on its loans in the early 1990s, for example, the business was quite
sound. The banks were able to arrange the company as a going concern and
refloat it. Given the level of intangibles (being the mastheads, such as the brand
name of the Sydney Morning Herald), there would have been little point to
winding up the company. Can we demonstrate how this would occur? The
following example should help us.
Big Bank is again having problems with Little Company (some lenders never
learn!). Having found its way out of trouble, Little Company finds that it owes
senior bond holders $75 and Big Bank $500. It still costs Little Company $15 to
run the company and, if it continues, it will be worth $520 with a probability
of 0.75, otherwise zero. The liqUidation value of the firm is $90 and Little
Company wants to default. What should Big Bank do? This is a simple process
of computing pay-offs.
1. The bond holders would prefer to liqUidate because they would receive $75
with certainty; otherwise, their expected payment is $67.50 ($90 multiplied
by 0.75, taking into account that we are looking at the start of the period,
not the end).
2. Big Bank's expected pay-off is $350 ($500 multiplied by 0.75) if the firm
continues; otherwise, it receives only $15 from liquidated funds. The bond
holders are seen to be the senior lenders in this example and $15 would be
the residual after they are paid.
3. Little Company has little incentive to continue, not wanting to lose $15.

andmanagement
Big Bank, therefore, needs to restructure the debt to ensure Little Company
will want to continue, but not lose in liquidation. The process is quite simple.
Big Bank needs to buyout the senior bond holders and find Little Company's
break-even point.
Big Bank's loan is now $575 (original loan plus bond holder debt of $75), so
we need to work out the break-even debt that keeps Little Company interested
in continuing. We do the same calculation as before:
0.75(520 - x) - 15 = 0
where
x = 500, which represents the loan amount that ensures Little Company will not
lose in liquidation.
We need to compare the $500 against the liquidation value rather than the debt
of $575.
Thecoordination
problem
In the previous problem, we assumed that the senior bond holders would be
happy to be bought out by the junior debt provider. In our example, this would
be true because the bond holders would receive full value for their debt. In
many restructures, however, not all debt holders receive their full entitlement
and they can hold up restructures by demanding to receive their repayments in
full. This is known as the coordination problem.
Much of the syndicated debt in the 1980s was arranged along these lines,
with many banks being involved. The important point of these arrangements
was that relatively junior lenders were in a position to affect the restructuring
process by stopping the rollover of facilities. That junior lenders were in such a
position of power may be construed as faulty contract design.
We return to Big Bank and Little Company to see how junior lenders can
have an effect on the senior lenders' position with problem loans. In this
example, we find that Big Bank is the senior creditor, ahead of two bond
holders (one senior and the other junior). Big Bank is owed $300, the senior
bond holder is owed $100 and the junior bond holder is owed $50. Given
business conditions, Little Company wants to restructure the business and
offers two plans: A and B. Plan A offers a pay-off of $400 with a probability of
0.7 and $100 with a probability of 0.3. Plan B offers a pay-off of $500 with a
probability of 0.5 and $100 with a probability of 0.5. How would we consider
the problem?
The first issue is to look at the pay-off of the company under each plan:
Plan A = $400 x 0.7 + $100 x 0.3 = $310
Plan B = $500 x 0.5 + $100 x 0.5 = $300.
The expected pay-off for Big Bank as the senior lender would be:
$300 x 0.7 + $100 x 0.3 = $240.
What does this tell us? Plan A would leave $70 for the remaining lenders and
Plan B would leave $60. This is clearly not enough. There are two possible out-
comes to this situation: (1) the junior lenders will need to take a smaller
pay-out under the restructure or (2), as occurs in many instances, the junior
lenders force the senior lender (Big Bank, in this case) to take out some of their
loans in return for allowing the restructure to continue.
The latter case demonstrates what is known in academic literature as a 'time
inconsistent contract'. When loan contracts and lending policy are put in place,
they should not be exposed to any unintended renegotiation. This destroys the
incentive of borrowers and lenders to perform their obligations.
In the next section, we will discuss covenant breaches. Whereas covenant
breaches normally put loans into technical default, there are many instances
where borrowers offer a penalty payment for breaches of covenants rather than
go into default. To accept this offer, the lender implicitly destroys the incentive
of the borrower to exert effort to continue to perform under the terms of the
lending contract. Such contracts go from time consistent (no re-negotiation in
the event of default) to time inconsistent. Knowing that the lender acceded
once, the borrower is under less pressure for the next breach.
When the out a life example of a loan default, it is usually in

the context of terrible hardship. Does this tell us that the theoretical principles
discussed in cannot work in real life? We can look at a number of
high-profile restructures: Fairfax, mentioned earlier, is one and Burns Philp &:
Co. (Bums Philp) is another. It is instructive to look at the Burns Philp case.
In Burns Philp was regarded as a well-run blue-chip company that had
been in operation for 116 years. No-one could have predicted what would
happen to the company when it suddenly wrote down $700 million of its assets,
Before the write-dow-n known, the value of Burns Philp shares was $2.50;
after, it dropped tCl $0.05.
While the Was dramatic and income levels also fell to levels that
made repaymento,(qebt difficult, the immediate concern was that Burns Philp
technically breacheditsdebt covenants. In particular, one business was written
down by $700 rnilJion,having an immediate impact on shareholder funds. This
hadthe effect Qfdramatically changing the debt-equity ratio .
•While.it isdifficlllt to surmise the detail of the considerations of the banks,
...reasoIijlbly suggest a number of things. First, it is not clear whether
Philp cO\i.ld.repay its debt. The fact that one major business sector was
written down by $700 million would seem to indicate that future prospects
!l.e>t800(:1. SOme media statements, however, seemed to indicate that debt
repayments were possible as long as a capital restructure was imminent.
agreement on their
'T¢IC/u:lre,cl
until the whole situation
.... liquidate and take sig-

strucllttre tlllb,tlf;iness. The theory we have con-
needed tQ.,.compare the economic worth of the
of the debt. ThiSis where the theory becomes difficult
observer). .. ..
is what type of financial distress are we considering
of the firm was likely to have been less than the
mild financial distress. Yet without extra data, we
moderate and severe financial distress. The solution
some clues.
from the debacle. The restructure has involved a
sold off, providing cashflow to repay debt

in the form of converting preference shares to bolster
was negotiated.
straightforward. Offshore debt holders proved to be dif-
of court actions occurring before agreement on arrange-
ments. (This is evidence of the coordination problem.) Further, points one and
two of the above solution are more aligned to the solutions of mild and mod-
erate financial distress than to the probable severe financial distress of this case.
In any event, Burns Philp's credit rating has been steadily increasing recently
- proof that liqUidating assets is not always the best course of action.
Source: Based on information obtained from the sources listed in the 'References and further reading'
section at the end of this chapter.
Otherbreaches
In concluding this section, it is worth recognising that not all defaults are gen-
erated by missed loan repayments. With many company loans, the approval of
the loan is subject to the company agreeing to various conditions, based on
financial ratios. These give a lender some comfort that:
• cashflow will not be unduly withdrawn from the company that would be
available to repay loans
• the overall risk of the company cannot be substantially changed.
Such ratios are known as covenants and are normally written in such a way
that a loan is repayable if a covenant is breached. Covenants can include:
• gearing ratios
• dividend pay-out ratios
• interest coverage.
The question then becomes: what is the correct procedure to follow when a
company breaches its covenants (a technical default) rather than misses a
repayment? There is no reason not to follow the principle of assessing the econ-
omic worth of the firm.
If the breach proves that the firm has become unviable, which is what a breach
of a cashflow covenant would probably show, then remedial actions can be taken.
Often, however, a breach of covenant has not affected the company's ability to
make normal repayments, in which case the covenant should be renegotiated.
Examples
fromthelaw
The previous section was deSigned to highlight that liquidation is not always the
appropriate action when debts are not repaid. In many cases, however, restructure
of debts will not be possible and liqUidation of the company will be the only
course of action. This text is not intended to be a legal text, but the following
information should be useful for understanding the winding up of debts.
In most cases, a lender appoints a liquidator to wind up a company that is
not in a position to repay its debt. If the lender is secured, then actions will be
taken to sell the security to repay the lender. The situation is not so easy if the
lender is not secured. The liquidator assesses the amount that can be recovered
from asset sales. Generally, this amount is less than the total amount owing and
lenders normally write off the remaining amount. While this is simplistic, some
court decisions on lending and problem loans highlight the care that should be
taken when lending.
In a celebrated case, the State Bank of Victoria lent money to the Victorian
Division of the National Safety Council. The monies were meant to be secured by
containers of sophisticated rescue equipment worth $250 000 in total; in reality,
however, they were empty and sold for $1592 each. The problem here was that
lenders had not exercised due care in investigating the security and examining the
company. The judgement of the case was scathing of the conduct of bank officers.
TtJe
likelilleod
tllalllteIUjorbanksdllift Dadloan,rovis.ons
How the banks fare iIl relation to bad debts Will be among the key points of
interest in the upcoming 12001j·reporting season.
Any sign that they are facing a marked deterioration in the quality of their
loan books is likely tolead to a sharp downward re-rating of the sector, particu-
larly if it is accompanied by more weak economic data in the coming weeks.
All the major lta,nks have suffered at least several large problem loans in
recent months. Moslnotable are cases like HIH Insurance (Westpac) and Harris ..
Scarfe (ANZ).
However, have put these collapses down to one-off examples of •..
bad than a signal of worse to come.

andmanagement
of risk I
· does concern that the
are likely to raise bad loan pro-

UTn .... rt .put them at their highest level
credit quality. That is the main

aid Perpetual 1rttstees fund manager Mr John
a bad debt cycle, it doesn't end as quickly as people
peaked at about 6 per cent of total assets at the

in 1992. That ratio slipped below 1 per cent in
there since.
the credit cycle is quite mature, so you would
, Mr Sevior said.
likely to lift bad loan provisions', Australian Financial Review. 23 April,
The above article highlights analysts' views that bad debts are likely to
increase in the current business cycle. Note, however, that this increase does
not seem to be linked to high-profile losses such as HIH Insurance and so on,
which are seen as 'bad management rather than a signal of worse to come'. The
article does not seem to indicate whose bad management. It does seem to indi-
cate that bad debts will pick up for the following two reasons:
1. Given that impaired assets are at a historic low, the trend would indicate
that more impaired debts must be around the corner.
2. Given that the credit cycle is mature, a pick-up in impaired debts must be
expected.
The reasoning is quite interesting. Is it alluding that credit growth is now
slow and that banks are lending at the margin, inviting the probability of
impaired assets? Or, could it be that lenders, given the low level of impaired
assets, are more inclined to take risks? Without a detailed examination of credit
policy, it is difficult to know.
Summary
1. Why do loans default?
Loans default for a number of different reasons. Most reasons are not 'bad
luck; rather, they are poor lending practices. The reminder is always
there that some loans in a portfolio will default.
2. What is the extent of problem loans?
The experience has been that the level of problem loans does not remain
static through time. Quite often, the number of problem loans is influenced
by factors such as the business cycle.
!" -
3. Why is the business cycle important for problem loans?
The ability to repay loans depends on the ability to generate cashflow. A firm's
or individual's ability to generate cashflow can be affected by the general state
of the economy. During a recession, demand is dampened, as is earning; the
reverse occurs during expansion and booms. It is no surprise to find that
problem loans increase during a recession.
4. How would you define problem loans, provisions and regulatory issues?
The treatment of problem loans tends to be driven by regulatory require-
ments. A problem loan is generally defined by the lateness of repayment,
with the benchmark being ninety days. After this time, a lending institution
will make provisions for that loan. The provision will be either general or
specific. The regulatory authorities specify statutory provisions. If the loan is
deemed to be irrecoverable, it is written off.
5. What are the capital issues of problem loans?
Problem loan management also has an impact on the allocation of capital.
Capital allocation for loans covers unexpected losses, so it is not surprising
that many lending institutions align their provisioning policies with their
capital policies.
6. What is structure dynamic provisioning?
As noted, problem loans can introduce volatility into a lending institution's
earnings. In recognition that problem loans will occur, lending institutions
seek to use their historical experience to forecast future problems and thus
smooth the problem loan experience. This method is known as dynamic
provisioning.
7. How are problem loans restructured?
There a number of ways of dealing with defaults. The approach taken will
depend on the extent of financial distress being experienced by the borrower.
There are three types of financial distress: mild, moderate and severe. The
general approach is to compare the economic value of the firm with the
repayment schedule.
S. What do cases from law illustrate?
In illustrating the issue of generating problem loans, legal cases often find
that blame lies with the conduct of lending officers investigating the security
and examining the company.
terms
bad debt write-off, p. 396 general provisions, p. 395 provisions, p. 395
business cycle, p. 391 impaired assets, p. 391 severe financial distress,
coordination problem, liquidation, p. 393 p. 399
p. 403 mild financial distress, specific provisions, p. 395
dynamic provisioning, p. 399
p. 393 moderate financial
distress, p. 399

Discussion
questions
1. Why are problem loans an issue?
2. Explain the difference between accounting, regulatory and internal pro-
visioning policies.
3. Why are some parts of the business cycle identified with increased
numbers of problem loans?
4. Compare and contrast dynamic provisioning and other methods of
assessing provisioning.
5. Discuss the advantages and disadvantages of dynamic provisioning.
6. Explain how to distinguish between the various forms of financial dis-
tress.
7. Would the timing of the business cycle influence the management of
the business cycle?
8. Ifi Corporation has two loans outstanding. One loan is to Certain Bank
for $400, while a senior bond holder is owed $150. Ifi Corporation
wants to put itself into liquidation and default on its loans. The liqui-
dation value is $160. The management of Ifi Corporation has speCial
qualities that would result in a pay-off of $420 with a probability of 0.8,
otherwise zero. For the management to continue, it would have to be
paid $10. Carefully outline the options available to Certain Bank.
9. In the case of a syndicated loan, there are often senior and junior debt
providers. Where a borrower defaults under this arrangement, the
senior debt providers would be assumed to be relatively well protected.
Under what circumstances does this not occur? What steps should be
taken to protect senior debt providers?
10. What steps would you take if a borrower breached a covenant, leading
it to technical default? Your answer should highlight the contract
issues.
References
andfurtherreading
Australian Prudential Regulation Authority 2000, Guidance Note AGN 220.1, Impaired
Asset Definitions, September, Canberra.
Australian Prudential Regulation Authority 2000, Guidance Note AGN 220.2, Security
Valuation and Provisioning, September, Canberra.
Australian Prudential Regulation Authority 2000, Guidance Note AGN 220.3,
Prescribed Provisioning, September, Canberra.
Durie, J. 2001, 'Banks left Pasminco no choice', Australian Financial Review, 20 September,
p.68.
Golin, J. 2001, The Bank Credit Analysis Handbook, John Wiley & Sons, Singapore.
Greenbaum, S. J. & Thakor, A. V. 1995, Contemporary Financial Intermediation, The
Dryden United States of America Press, Orlando, Florida.
Hogan, w., Avram, K., Brown, C., Ralston, D., Skully, M., Hempel, G. & Simonson, D.
Mellish, M. 2001, 'Majors likely to lift bad loan provisions', Australian Financial Review,
23 April, p. 41.
Shanmugham, B., Turton, C. & Hempel, G. 1992, Bank Management, John Wiley &
Sons, New York.
For the Burns Philp analysis on pages 406-7

Bartholomeusz, S. 1998, 'Banks hold the switch on Burns Philp's life support', The
Age, 'Business' section, 11 June, p. 3.
Carr, M. & Rogers, I. 1998, 'Burns Philp cuts a $700m deal with its banks', Australian
Financial Review, 18 August, p. 1.
Commonwealth of Australia bank, www.comsec.com.au.
Knight, E. 1997, 'Not broke but a basket case', Sydney Morning Herald,
24 September, p. 25.
Mitchell, S. & O'Riordan, B. 1997, 'Key staff as Burns Philp awaits nod from bankers',
Australian Financial Review, 19 December, p. 23.
Sykes, T. 1998, 'US banks raid Burns Philp debt', Australian Financial Review,
11 June, p. 21.

Introduction
Earlier chapters explained the principles of lending and their applications in the
context of business and household borrowers. We have so far assumed that finan-
cial services are delivered in the traditional way: that is, through brick-and-mortar
branches. In recent years, however, there has been a rapid shift towards electronic
distribution of financial services. This shift has been due to two factors: first,
most financial transactions are repetitive in nature, so financial institutions have
found it cost-effective to deliver services electronically (a supply-side push); and
second, users of financial services (bank customers) have been equally enthusi-
astic in their willingness to adopt technology (demand-side pull). Driven by
mainly these two factors, electronic delivery of financial services has rapidly
expanded. There are hardly any financial institutions that do not deliver services
electronically or do not use technology in their operations.
Given the rapid expansion of technology for banks' delivery of financial ser-
vices (including lending), it is important to be aware of the issues involved. The
issues in electronic lending are no different from those that one encounters in
electronic banking in general. In this chapter, we will explain these issues. In
particular, we will cover what electronic banking is, how it has evolved, what
the status of electronic banking is in Australia, and what regulatory and other
issues arise in the electronic delivery of financial services.
Whatis electronic
banking?
Weaver and Shanahan (1994, p. 68) define electronic banking as 'the process by
which information can be accessed and applied electronically'. This includes
simple operations such as accessing account balances over the telephone or the
Internet and more complex operations such as transferring funds between
accounts. Electronic banking used in such a broad sense refers to all banking
activities and transactions that involve the use of some form of technology. This
broad definition includes telephone banking, credit cards and automated teller
machines, with which we are all familiar. Some authors prefer to use the term in
a narrow sense and apply it mainly to stored-value cards (smart cards) and
Internet banking. We will use the term in its broader sense, not only because it
is technically more appropriate to do so but also because it helps us to see elec-
tronic banking as it has evolved over the years. Roger Ferguson (1998, p. 1), a
member of the Board of Governors of the US Federal Reserve System, states that
'defining electronic banking in this way has many advantages, not the least of
which is that it helps us to see electronic banking as a continuum that has been
evolving for quite some time. An implication of this perspective is that lessons
learned from the past electronic developments may help us better understand
both today and the future'.
A distinction is sometimes drawn between electronic payment systems and
electronic banking. Electronic payment systems refer to payments made by elec-
tronic means. Electronic banking is a more general term and includes, alongside
I 414 Pari 6: Currentissues

electronic payment systems, other electronic banking transactions such as
lodging applications, checking balances and transferring funds. Such a distinc-
tion between an electronic payment system and electronic banking is really not
necessary. When, for example, one uses electronic funds transfer at point of sale
(EFTPOS) to make a payment, the bank account (cheque or savings) is auto-
matically debited. Payment systems are thus closely linked with banks; that is,
a distinguishing characteristic of banks is that they facilitate payments. In this
chapter, therefore, we will use the term 'electronic banking' to include elec-
tronic payment systems.
An understanding of electronic payment systems and electronic banking and
lending is facilitated by knowing how they have evolved over the years. This
knowledge also indicates the direction in which electronic banking is heading.
In the following section, we will trace the evolution.
Theevolution
ofelectronic
banking
The application of technology in banking dates back to 1920. In the past eighty
years, financial institutions have used technology to transmit information,
receive information and transact business. The quality, range and price of elec-
tronic services are an important part of a bank's competitive armoury in its
approach to corporate and personal customers. Banking transactions have been
found to be most amenable to technological use. They are repetitive in nature
and voluminous, few parties are involved, and back-up records are needed.
These characteristics of banking transactions have led to ongoing efforts to
automate the transactions. Financial institutions have always been the first to
make use of changing technology. Without the push from banks, perhaps the
progress of technology would not be as advanced as it is today.
According to Deakin and Goddard (1994), the Federal Reserve Communi-
cation System (Fed Wire) is the parent of all banking technologies that followed.
Fed Wire was a system for transmitting bank funds, which eventually led to
transferring funds at retail customer and corporate levels. As early as 1920, Fed
Wire had recorded over 700 000 transfers. The transition from Fed Wire to retail
banking transactions using technology, however, took a long time. Deakin and
Goddard argue that the effectiveness of the early electronic banking system was
inhibited for the following four main reasons:
1. Communication technology was in its infancy and inadequate for local or
global coverage. Banks or customers could not communicate internationally
within their own organisations or with each other.
2. Most companies and banks had incompatible systems; sometimes, even dif-
ferent branches of the same banks had different systems.
3. Computer manufacturers were unable to agree on the development of tech-
nology standards that would permit direct data exchange between computer
systems.
4. Computer hardware and software were expensive compared with the
efficiency savings available through automation.
The search for efficiency and pressures for improved service (particularly
pressure from corporate customers) led banks to spend time and money on
devising faster means of conducting banking transactions. US banks took the
lead and began technology attacks on European banks, which had an exclusive
hold on European corporate customers.
With competition increasing, the UK banks also made forays into electronic
banking. The Barclays Bank made the first automated teller machine (ATM)
available to the public in the United Kingdom in 1969. Another step forward
was the introduction of the Bankers Automated Clearing System (BACS) in
1971. The aim was to address the escalating cost of clearing credit transfers. In
1977, the Society for Worldwide Interbank Funds Transfer (SWIFT) was set up,
beginning operations for international payments. Credit Agricole of France
introduced EFTPOS in 1979. Banks continued to develop electronic funds
transfer systems, and the Clearing Houses Automated Payments System
(CHAPS) opened in February 1984. From 1985, electronic banking progressed
considerably, spurred by two technical developments:
1. the production of cheap personal computers
2. new packet switching techniques, which made improved communications
available and provided the mechanism for national and international data flow.
Deakin and Goddard (1994) state that the following occurred as a result of
these developments:
• By 1985, elec.tronic banking had progressed considerably and was well
established in the United States.
• The UK banks started competing in this area with US banks.
• The use of personal computers was growing.
• The majority of electronic payments were still between banks but corporate
customers were participating more and more in electronic banking
transactions.
This progression led to several uses of technology in banking transactions:
• Corporate treasurers could receive and use data directly from banks.
• A company's daily bank account details could be collected into proprietary
spreadsheet packages and used in financial analyses for managing cashflow
forecasts and conducting 'what if?' analysis.
• Balance reporting systems started to become popular in interbank/corporate
transactions.
The early 1990s marked a watershed in the history of electronic banking. In
1990, the Advanced Research Project Administration Network (ARPANet) of
the US Department of Defence was officially decommissioned. This meant that
the Internet was made open for commercial use and thus Internet commerce or
(e-commerce) was born. As the electronic trade grew, an appropriate payment
system was needed to make payment for the goods or services purchased over
the Internet. An electronic payment system soon evolved, but it required links
to bank accounts - eventually, a full-fledged electronic (Internet) banking
system evolved. The process is not complete yet and the latest step is the advent
of mobile phone banking (or m-banking, as it is called).
I 416 Part6: Currentissues I

Given that electronic payment systems and transactional Internet banking are
the major components of electronic banking, we will explain these concepts in
more detail.
Electronic
paymentsystems
We are all familiar with the traditional payment systems: that is, cash and
cheque. These involve delivery of cash or an instrument of payment (cheque)
from one party to another. In electronic payment systems, no such physical
delivery takes place; instead, the payment is made by one party to another elec-
tronically, which means the account of the payer is debited and the account of
the payee is automatically credited.
According to the Bank for International Settlements (1999), the noncash-based
systems (other than cheques) consist of the following payment systems.
Directentrytransactions
Direct entry payments are exchanged by direct computer-to-computer links.
Such payments are usually bulked. In Australia, such exchanges take place
between two parties (institutions) - that is, bilateral exchange rather than
through a central automated clearing house, as in some countries. Direct entry
transactions could be debit or credit. We usually come across direct credits
when regular payments such as salary, social security benefits and dividends are
involved. Direct debits are made when financial institutions collect loan repay-
ments. They are also used when insurance companies collect regular premiums
and utilities collect payments for energy bills. For Government payments, the
Reserve Bank's Government Direct Entry Service (GDES) is generally used. The
value exchanged through direct debits in 1998 was $608 billion, representing
12 per cent of the value of retail noncash payments (Bank for International
Settlements 1999).
Creditcards
Plastic cards are being increasingly used in Australia to make payments. Plastic
payment cards can be of three types: debit cards, credit cards and other cards
such as travel cards, entertainment cards and retailer cards. By using debit
cards, customers can access funds that are already in their account. Banks,
credit unions and building societies are the main issuers of debit cards. These
cards can be used at ATMs, EFTPOS terminals, telephones and automated
petrol dispensers. In 1998, around 16 million debit cards were on issue in Aus-
tralia. Credit cards provide access to pre-arranged revolving credit up to a speci-
fied limit. Credit payments can be made for the purchase of goods and services
up to that limit. The issuers usually send a credit card statement every month to
the card holder, specifying the amount used and the balance available. What-
ever amount the card holder repays becomes available for use in addition to the
unused balance. Most credit card issuers offer a choice between credit cards
with and without an annual fee. Credit cards with the fee usually offer an
interest-free period of fifty-five days, while those without the fee do not have
any interest-free period and carry a higher interest rate. In 1998, 10 million
credit cards were on issue in Australia and were used to make transactions with
a total value of around $42 billion. Also called charge, store and private label
cards, the travel, entertainment and retailer cards allow the user to defer pay-
ment from the date of purchase until the account due date. No revolving credit
is involved and the whole of the outstanding balance is payable on receipt of
the monthly bill.
ATMs
Whenever customers present bearer cheques or withdrawal slips, bank tellers
make payment across the counters. The installation of ATMs has replaced many
tellers, and payments can now be obtained by inserting debit or credit cards
into an ATM and keying in a personal identification number (PIN) and other
details. ATMs offer considerable convenience, because cash dispensing is poss-
ible twenty-four hours per day instead of just within banking hours. ATMs were
introduced in Australia in 1981; by June 1998, there were 8814 ATMs
throughout Australia. The national number rose to 11915 by June 2001.
EFTPOS
EFTPOS in Australia requires the use of a PIN and debits the customer's
account in real time. The bank that acquires the transaction (called the acquirer
bank) guarantees the payment to the merchant. There were 218 330 EFTPOS
terminals in Australia in June 1998, rising to 362848 by June 2001.
Storedvaluecards
As the name implies, these cards have a stored value. They can be used to make
payments up to that value. The terminal where the card is used reads the value
on the card and displays the balance on the screen. It also automatically deducts
the value used. A common example is Telstra's prepaid Phonecard, which is
used for making calls from public telephones. You may also be familiar with
another type of stored value card: the value reloadable card that you use for
photocopying at tertiary institutions.
E-cash
In June 1997, a regional bank started issuing DigiCash (Australian
dollar-denominated electronic cash). This system requires both the consumer
and the merchant to have an account with the same bank. The consumer can
then purchase e-cash from the bank to pay for any purchases made from the
merchant.
Electronic
datainterchange
Electronic data interchange (EDI) involves the exchange of information in a
standard format from computer to computer. EDI is most commonly used in
retail, transport, automotive and other such industries. In Australia, five main
value added networks (VANs) are used for EDI purposes. Australian banks
receive EDI payment requests from their customers direct or by logging into a
VAN.

BPAY
BPAYis a third-party bill payment service owned by banks. The system allows
customers to transfer funds using telephone or Internet banking.
Interbankexchange
andsettlementcircuits
Interbank payments and settlements occur through the Australian Payments
Clearing Association (APCA). After the Commonwealth Government accepted
the recommendations of the Wallis Report (1997), the APCA ceased to exist
and its functions were moved to the Payments System Board within the Reserve
Bank of Australia. These general-purpose payments clearing systems handle
three types of payments; cheques and other paper instruments; bulk electronic
(direct-entry) payments; and large-value electronic payments.
Other paper instruments are cleared through the Australian Paper Clearing
System (APCS). Large-volume electronic credit and debit transfers are processed
under the Bulk Electronic Clearing System (BECS). For large-value payments,
there are three systems operating in Australia: the SWIFT Payment Delivery
System (PDS), the Reserve Bank Information and Transfer System (RITS) and
the Financial Transactions Recording and Clearance System (FINTRACS).
These three systems account for over 90 per cent of the large-value payments.
All three have operated on a real-time gross settlement (RTGS) basis since June
1998.
In Australia, ATM, EFTPOS and credit card transactions are currently cleared
under bilateral arrangements between participants. For clearance of BPAYtrans-
actions, multilateral arrangements exist, but outside the auspices of the APCA.
Electronic
banking
We will now look at electronic banking (that is, activities other than electronic
payment systems). We will explain three major electronic banking systems:
home banking, Internet banking and mobile phone banking.
Homebanking
According Weaver and Shanahan (1994), home banking (also known as telephone
banking) allows the customer to use the telephone or computer screen to check
account balances, transfer money between accounts, pay bills and check on a
limited number of recent transactions. The broader definition of home banking
therefore includes banking using personal computers as well as telephones.
For personal banking, consumers can use modem connections and specially
tailored software installed on their computers to undertake banking transactions.
The Wallis Report (1997) found that relatively young and affluent households
were more likely to have personal computers and modems, but the extent to
which this equipment was being used for home banking purposes was not great.
There is thus scope for growth in its use, especially as home banking functionality
improves. The Wallis Report found that 47 per cent of Australian households
own personal computers and 15 per cent have a modem. (As per the latest avail-
able data published by the Australian Bureau of Statistics [cat. no. 8146, 2000],
53 per cent of Australian households had access to a computer at home in 2001
and 33 per cent had home Internet access.) Home ownership of computers may
also understate the possible market penetration of this channel. Many workers
have access to a computer in the workplace and choose to conduct banking
during business hours.
Internetbanking
The need for proprietary software (that is, software provided by the bank)
restricts the use of banking via personal computers. One can transact banking
business only on a personal computer with such software. The solution is
browser-based banking, also called Internet, online or web banking. The Internet
can be accessed from anywhere in the world, so online banking is also possible
from any location and from any personal computer (not necessarily the ones on
which proprietary software has been installed). This has enormous advantages
because banking business can now be transacted wherever a computer with an
Internet connection is available. Many banks now provide an online banking
facility. If you have not already made such transactions, it is worthwhile to try
online transacting. You will soon realise the enormous convenience.
One shortcoming of Internet banking is that it requires access to a computer.
This means that bank accounts cannot be accessed anytime anywhere. Mobile
phone banking overcomes this shortcoming.
Mobilephonebanking
Wireless application protocol (WAP) enables mobile phones to facilitate access
to the Internet and thus to web banking. Bank customers can thus transact
banking business literally from anywhere if they have a WAP mobile phone. As
we will explain later, however, the use of mobile phones for banking trans-
actions is still in its infancy and many issues need to be addressed.
Having traced the history of electronic payment systems and electronic
banking, we will now turn to their use in the Australian context.
Trendsandissuesin electronic
bankingand
lendinginAustralia
The discussion of trends and issues in the Australian context is divided into two
sections. First, we will explain the trends and issues in retail financial services
technology and then we will discuss the use of technology for lending.
Trendsandissuesin retailfinancialservicestechnology
Anderson Consulting (1987) studied the trends and issues in retail financial
services technology. The following discussion is based on mainly the findings of
that study (updated wherever relevant).
Technology is regarded as the central element in retail banking due to the
advantages (such as improved productivity and profitability) that flow from it.
This is evidenced by the increasing expenditure on technology as a percentage
of non-interest operating expenses.
42D Pari6: Currentissues I

1980-85
The period 1980-85 marked the start of the deregulation process in Australia's
financial services industry. The Campbell Committee Report (1981) laid down
the foundation of deregulation in Australia, introducing competition in the
form of the market entry of foreign banks. Confronted by the deregulatory pro-
cess, the domestic financial institutions viewed technology as a defensive tool
to deter competition and also to improve customer service and support new
product implementation. According to the Anderson Consulting report, the
technology use during this period was characterised by the following six
changes.
Transaction processing systems technology
Technology was first introduced in banking operations in the late 1960s. The
job of transaction processing was repetitive in nature and thus amenable to
being handled by machines. Further, the paperwork was increasing at a phen-
omenal rate and human intervention for processing was both time consuming
and expensive. Technology was thus introduced to bring economies of scale.
Banks could process increasing volumes of business at relatively lower unit
costs. The use of technology at this stage, however, was fragmented. Systems
developed to improve customer service were largely add-ons to the existing
infrastructure, resulting in a myriad of different systems and technologies.
Use of technology to handle front-office branch operations
Technology was introduced mainly to handle front-office branch operations.
The back-office operations continued to be paper intensive. Technology use was
limited to certain accounting and reporting functions. The branch terminal was
connected online to the host processors, but the processors' low intelligence
severely limited the benefits accruing to banks.
ATMs
Westpac was the first bank to introduce ATMs to Australia in the 1980s. ATMs
were brought in to take over the branch teller cash-handling function. The
savings generated were expected to offset the equipment and network cost of
ATMs. Customers readily accepted the new technology and a rapid growth in
use ensued. The major banks found a competitive advantage over smaller
institutions and new entrants through ATMs. The smaller institutions thus set
up the Cashcard shared-ATM network.
Credit cards
Credit card use in Australia is one of the highest in the world. Credit cards
became popular in Australia with the launch of Bankcard in 1974, which was
backed by the major Australian banks. The Bankcard processing was provided
by the consortium company, Charge Card Services Limited, and involved a pre-
dominantly paper-based operation. Customer and retailer acceptance was wide-
spread, with over five million cards being issued. In the early 1980s, MasterCard
and Visa were introduced.
EFTPOS
EFTPOS was introduced in Australia in 1984 and the first terminals appeared in
Woolworths supermarkets and BP service stations under the sponsorship of
Westpac. The major banks soon joined the EFTPOS market. The card use was
restricted, however, to debit cards and as a substitute for cash and cheques.
After nationwide trials for about twelve months, further developments in the
EFTPOS system took place.
Change to package software
Before the 1980s, the major banks were using custom-developed transaction
processing systems. During the period 1980-85, the emphasis shifted to appli-
cation software packages. This was a low-cost and least-risky way of imple-
menting systems in a short time. Software packages have been used extensively
and successfully in the areas of delivery systems, EFTPOS and home banking.
The applications are less sophisticated and the volumes are significantly lower
than for transaction processing systems.
1986-89
Further important changes occurred in the period 1986-89.
Online retail branches
Banks started investing heavily in branch technology. Both back-office and
front-office functions were automated. Given that this was done at two different
times, however, 'appropriate integration between the two could not be achieved.
Shared ATM networks
Banks initially installed proprietary ATM networks, but this approach involved high
capital costs of equipment, transaction processing costs, maintenance costs and the
costs of holding idle cash. To reduce costs, shared networks were established.
EFTPOS
As with ATMs, network facilities for EFTPOS have been shared. There is now a
near-complete interchange of cards.
The rapid expansion of ATMs and EFTPOS were the notable events of this
phase. Competitive pressures led banks to find ways in which to improve
efficiency by reducing costs. For better cost management, however, there was a
growing need for improved information to support strategic decision-making.
The earlier focus on improved customer service and cost reduction changed,
and financial institutions began to look for a strong business case before intro-
ducing extensive new technologies.
1990sandtoday
The focus in the 1990s was on the development of integral customer infor-
mation systems. This is particularly important because developing a data struc-
ture based on customer information is the key to offering relationship banking
services. The role of brick-and-mortar branches is continually being assessed,
and banks are finding ways of reaching the customer electronically through
Internet banking and call centres. The following technologies are emerging.
422 Part6: Currentissues I

Truncation
Cheque-reading equipment with multiple medium capabilities has been intro-
duced on branch teller counters.
Image processing
Images of cheques can be captured and stored on an optical disk. This capa-
bility overcomes the storage and retrieval limitations of micrographics.
Wholesale banking
The proliferation of new banking products and the speed of their introduction
to the marketplace led to the need for systems to be quickly developed. As a
result, banks were left with having multiple applications running in different
environments, with each application tailored to meet a speCific user need. The
decision-making had shifted from a centralised process to the end users, who
assumed a critical voice in the choice of applications. The result was the cre-
ation of a highly inefficient environment, because lack of integration leads to
risks with data capture and consolidation. In this environment, IBM dominated
the international banking market with its mainframe and proprietary software
such as CICS, MVS and IMS.
Then came the personal computer/workstation revolution. Personal com-
puters have high-power processing capabilities, which have proved excellent for
sophisticated computations and graphics, and are clearly appealing for their
user friendliness. Despite these advantages, the mainframes remain the better
tool to manipulate large amounts of data, espeCially given that data retrieval is
still a mechanical process. Studies show that the maintenance cost per user is
twice as expensive on a personal computer/workstation basis as for a mainframe
environment. It was thus realised that the two technologies are not competing
with each other, but complement each other.
Relational technology
Creative and efficient use of technology is a critical success factor for financial
institutions to sustain high-quality customer service levels and to remain
competitive. The main advantages that flow from the relational approach are
flexibility, adaptability, productivity, around-the-clock operations and data inde-
pendence. Relational technology is a powerful and flexible way in which to pro-
vide access to information, without requiring complex programming routines.
Many of the back-office applications have been driven by past development
approaches and by the technology that was available when the system was being
developed. Financial institutions have to determine whether they should con-
tinue with a piecemeal approach to developing technology (in the form of
add-ons) or rewrite the architecture to fully leverage relational technology.
Relational technology provides the business with a powerful shared infor-
mation-handling tool. It provides the means to begin an orderly migration from
legacy systems and provides the foundation for an infrastructure based on a
single real-time database repository, which can store a vast amount of data and
present the data to an audience of users with a wide range of needs.
Legacy systems
Legacy systems refer to the systems inherited from the past. They rep-
resent monolithic applications that were developed with the technology of
the 1970s and 1980s, and that have become cumbersome and expensive to
maintain.
Legacy systems can impose the following severe constraints:
• inflexibiliity
• high maintenance costs
• high demands on existing budgets and thus a reduction in capital
expenditure on new business needs
• high demands on existing labour.
Financial EDI
The financial services industry is thought of as an ideal industry for using EDI.
Most of the documents are standardised, many forms are used, the processes are
repetitive, and the volume of transactions is large. Hendry (1993) explains that
ED! is the process of transmitting data by linking computers directly This pro-
cess avoids the use of printed forms, as are usually sent. EDI is generally con-
sidered to replace standardised documents such as order forms, delivery notes
and invoices. The technique is highly flexible and can be used in a large
number of applications in a wide range of industries. CHAPS is one of many
EDI services that operate between banks around the world:
According to Hendry (1993), ED! has the following advantages.
• EDI saves both time and labour by avoiding the need to rekey data.
• Errors introduced by rekeying are eliminated.
• Data arrive much faster than by mail, and there is an automatic acknowledge-
ment of receipt.
• EDI imposes a fairly strict discipline on its users.
The following are among the disadvantages:
• Institutions have to change operating procedures to suit EDI.
• EDI is less transparent than a paper-based system; for example, if priorities of
orders are to be changed, then it is easier in a paper-based system than in
ED!.
• When messages can be sent by fax as fast as by EDI, some users feel there is
little to gain from EDI.
• If computers fail, then the operation halts. A back-up system is required.
EDI involves the following costs:
• implementation costs (purchase of hardware and software, installation of
telephone lines and communications equipment, training and management
time)
• running costs (rent of telephone lines, call or packet charges, maintenance
and so on)
• reorganisation costs
• feaSibility study costs (researching the market, deciding whether to use ED!
and so on).
424 ParI6: Currentissues I

The benefits of ED! include:
• faster transaction turnaround
• less paperwork
• savings in staff time
• fewer errors
• reduced inventory levels (because orders can be placed instantaneously and
replenishment can be automatically requested)
• reduced payment periods
• improved service to customers
• closer contact with customers and distributors.
In the absence of EDI, financial institutions need to have separate links with
computers of other institutions; with EDI, all institutions need to have only one
link with the central computer. It is possible to use formats by linking two com-
puters, but EDI is more cost-effective when many suppliers and consumers are
involved. Most EDI systems use wide area networks (WAN) such as public
switched truck network (PSTN) or a packet switched network (X.2S). It is
important, therefore, that only authorised people have access to data on the
system.
The first EDI systems in banks were a part of the clearing system. With a
computerised system, it is a lot more easier to 'net' transactions - that is, sub-
tract the money owed from money to be received.
Emerging
roleofbanksin e-commerce
Banks are responding to the opportunities created by the rise of online com-
merce. Many banks have already implemented a cost-efficient electronic access
channel for traditional products. They are offering new products especially
designed for e-commerce. As banks enter the electronic arena, they are finding
that new opportunities bring new operational and strategic risks.
nar'kets, improving cus-

[eUlvn.V: Companies have tra-
and customer data. Now,
enabled firms to streamline
retailers through the ele.
0
steps to expand the use ....

. n:e:lworking operations. For these institutions,
n(:>.Wever,the electronic commerce poses questions as well as
(continued)
/" -
opportunities. Will the role of banks in e-commerce basically mirror their role
in traditional commerce? Or will banks offer new products that will change the
nature of the banking business as e-commerce expands? What risks might
accompany such a shift in banks' traditional business?
E-commerce will create new forms of competition and compel banks to
make choices about the services they offer, the size of their branch networks,
and the extent of their support for interbank payment networks. Participation
in e-commerce will also increase banks' exposure to technological problems.
Banks' success in coping with such challenges will help determine the scale of
their influence in the electronic marketplace.
Advantages of e-commerce for banks
Banks have an important reason to pursue the conduct of business online. I f
they fail to respond to the opportunities posed by the Internet, they could be
consigned to a largely secondary role as commerce shifts toward electronics
over time. In that event, they would process payments for buyers and sellers
engaged in e-commerce (see solid lines on figure), but they would have little
chance to engage independently with buyers and sellers or to offer their own
products in the electronic marketplace. By contrast, if banks do establish a pres-
ence on the Internet (see dotted lines on figure), they should be in a position
both to market traditional banking products more efficiently and to develop and
sell new products sought bye-commerce participants.
Role of banks in e-commerce
Buyer ---. E-commerce

over the Internet .- Seller
I
....
\
I \
I \
Payment I \ Payment
I \
instructions I
I \
\
instructions
I \
I \
1 1
I \
I \
t \
I \
I \
I \
Buyer's
bank ---. Bank payment
networks .- Seller's bank
Source: Extract from J. Wenninger 2000, 'The emerging role of banks in e-commerce', Current Issues
in Economics and Finance, Federal Reserve Bank of New York, 6(3), pp. 1-2.

We will now turn to the use of electronic systems for lending activities in
Australia.
Useofelectronic
systems
forlending
As you have already learned, banks are increasingly turning to technology to
reduce costs. The use of technology, once confined to transactional banking, is
now being extended to lending. Electronic devices are increasingly being used
in Australia for the provision of the following lending services:
• Information about lending products and services is available on the Internet.
• Applications for some lending products (home loans and margin loans, for
example) can be electronically lodged.
• Features of lending products offered by different institutions can be easily
compared across websites.
• Applications for lending products (credit cards and margin loans, for
example) can be electronically lodged, processed and approved.
• Loan accounts can be viewed on the Internet.
• Electronic transfers to and from loan accounts are possible.
Some of the commonly used electronic devices for lending activities by banks
are as follows:
• ATMs are being used to market lending products. You may have seen lending
products being advertised on ATM screens.
• Telephone banking is yet another electronic device being used to market
lending products. Much of the information that one needs about lending
products can be received over the telephone.
• Internet banking is the latest electronic device, which is used not only to market
lending products but also for actual lending. Applications for lending products
such as credit cards, personal loans and home loans can now be lodged over the
Internet. In the United States, the Small Business Administration provides
electronic lending services to small businesses. The details of these lending
services can be found at www.sba.govlbankinglindexmicroloans.html. Online
origination of mortgages, home equity loans, personal lines of credit and credit
cards is the most promising way to earn profits from online initiatives. In the
United States, although less than I per cent of the $2 trillion consumer loan
market is originated online, a substantial portion of online households use the
Internet to research rates before applying. Innovative lenders in the United
States, such as IndyMac, DeepGreen Bank, Wells Fargo and Lending Tree, have
already figured out how to turn the vast hordes of lookers into profitable loan
originations.
Table 14.1 on page 428 (compiled from the websites of major Australian banks)
indicates the various lending products offered by these banks online. Some credit
unions and building societies have also started to offer electronic lending services.
These services are primarily confined to personal and home loans. Such financial
institutions include Island State Credit Union (www.islandstate.com.au). Connect
Credit Union (www.connectcreditunion.com.au) and the Heritage Building Society
(see http://secure.heritageonline.com.auILOANS/loans.html).
TABLE 14.1 Lending products available online from major Australian banks (at 13 December 2001)
Personal Credit Home Business

Bank loans cards loans finance
ANZ Y Y Y Y
St George Y Y Y N
Commonwealth Y Y Y Y
Westpac Y Y Y Y
National Y Y Y Y
Y = available online; N = not available online
The above table shows that all the major banks in Australia provide personal
loans, credit card loans and home loans online. Except for St George Bank, the
banks also provide business loans online.
The procedures followed by banks for online lending are similar to those fol-
lowed in traditional banking. The St George Bank website (www.stgeorge.
com.au, as shown in figure 14.1) indicates the following information is required
for online personal loans:
• a driver's licence number (if any) for each applicant
• net income details for each applicant
• the value of (!ny assets, savings and investments
• the account numbers, repayment amounts and balances owing for any
liabilities (including credit cards and store accounts)
• the name, address and phone number of the nearest relative/friend not living
with the applicant
• for self-employed applicants, the last two tax returns.
Applicants are also told that they should advise their accountant that the
bank may call to confirm details. The application form provided at the St
George Bank website can be completed in about twenty minutes. After the
application is submitted, a staff member may call the applicant to discuss which
account the applicant wants to use to make regular payments to repay any loan
approved. Tips for filling in the form are also given on the website.
For home loans, the St George Bank website provides information such as a
home loan calculator, the amount one can borrow, which type of home loan is
appropriate and the latest mortgage rates. With all the information available at
one place, along with the calculator, it becomes quite easy for a prospective bor-
rower to compute hislher home loan requirements in the comfort of hislher
home or office. It also enables the applicant to make informed decisions,
because he/she can compare the various banks' home loan products, fees and
charges online. Equipped with this information, prospective borrowers can
negotiate terms best suited to their needs.
In Australia, 'Lenders On Line' (www.LendersOnLine.com.au) and 'Home
Path' (www.homepath.com.au/guestlHL_HOME) are two of the popular websites
for online borrowing and lending. Home loan applications made through these
I 428 Part6: Currentissues

websites incur lower than normal loan establishment fees. For a home loan
application through 'Lenders On Line', for example, about half of the establish-
ment fee is waived. Similarly, the Commonwealth Bank of Australia exempts cus-
tomers who apply for home loans online from the application fee of $600. These
and such other incentives are intended to encourage online applications.
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FIGURE 14.1 An example of online lending - the St George Bank website

Source: www.stgeorge.com.au. accessed 3 October 2002.
Internet banking seems to be becoming popular in Australia. According to the

National Office for the Information Economy (2001 ), the number of Internet
banking users in Australia in the three months to September 2000 increased from
1.37 million to 1.75 million. Of the Australian respondents, 53 per cent (next to
only Hong Kong and Sweden) rated online banking as more convenient than
traditional banking. This shows the willingness of Australians to adopt tech-
nology. More importantly, 98 per cent of Australians currently banking online
will continue to do so and 32 per cent of persons who are online but not currently
using net banking will start online banking use in the near future (National Office
for the Information Economy 2001 ). All these trends augur well for the growth
of online banking and lending in Australia, but there are obstacles to rapid
growth. The KPMG (1998) Home Internet Banking Survey found that the key
issues faced by banks in their Internet deployments were:
• security concerns
• the development of internal understanding about the Internet as a service
delivery channel
• the internal transition of Internet management from information technology
units to business units
• resourcing.
Banks and governments in different countries have already taken several steps
to address these issues. If you are interested in knowing further details of
Australian banks that offer online banking services, the costs involved, the prod-
ucts and their features, and security and privacy issues, you may like to visit the
websites of different banks or refer to important publications by the National
Office for the Information Economy (Internet Banking Jar Business, Getting Paid
on the Internet and Setting the Record Straight about Online Credit Card Fraud).
Another development is the use of mobile phones for banking transactions.
The number of mobile phone users in Australia had increased to 45 per cent of
the population as ofJune 2000. More recent figures indicated that digital mobile
phone connections in Australia were expected to exceed 50 per cent of the
population by the end of 2000. As per the National Office for the Information
Economy (2002, p. 6), the current proportion is 64 per cent. Australia has five
mobile phone network operators: Telstra OnAir, Cable and Wireless Optus,
Vodafone, AAPT (Cellular One) and Hutchison (Orange). Telstra OnAir had
47.9 per cent of the mobile phone market at June 2000 (Ferguson 2000).
Research by Hannen (2000) suggested that by 2002, 45 per cent of Internet
users would be using handheld devices (rather than desktop personal com-
puters) for their Internet access. The above statistics show that Australians are
fast adopters of new technology and that the potential for a new platform for
delivery of banking services (via mobile phones) is good.
The Commonwealth Bank of Australia and Vodafone launched Australia's first
mobile telephone banking service on 23 November 1999. Another of the big four
banks, Westpac, launched its mobile banking strategy in alliance with Telstra in
August 2000. The remaining two big banks, ANZ and National Australia Bank,
have tested mobile banking services but have yet to put a service on the market.
St George Bank, which was the leader in launching the Internet banking service
in Australia, has not made any move so far into mobile phone banking services.
Exact statistics on mobile banking service users in Australia are not avail-
able, although a guess can be made from a statement by a senior executive of
Westpac. Henry Wendt, head of e-strategy at Westpac, states that 'although the
bank has more than 386 000 Internet banking customers, those that have
registered for mobile banking [are] in the hundreds' (Gibbons 2000a, p. 107).
Australia's mobile Internet market is estimated to comprise only about 50 000
consumers (Kennedy 2000).
Mobile commerce in general and m-banking in particular are almost non-
starters in Australia. They have not developed to a stage where any operator in
the market offers a wide portfolio of services. M-commerce and m-banking are
not new: they are just being offered on another platform. The development of
m-commerce is closely linked to the spread of WAP-enabled phones, which
explains why the spread of m-banking/commerce is tardy. Only an estimated
10 000 Australians have WAP-enabled phones (Gibbons 2000b). A recent
report from Forrester Research of the United States concludes that consumers
have little inclination to become involved in the wireless web at this stage, and
this US trend is likely to be mirrored in Australia (Bryant 2000). Some industry

experts disagree. Rosenberg forecasted that 'WAP services [would] be accessed
by at least five million Australian mobile phone users by December 2001'
(Dempsey 2000, p. 102), which would have required more handset penetration
and m-commerce applications to be available on the market.
Another area in which banks are increasingly using technology is credit
assessment. To determine the competitiveness of lending, banks are using credit
risk models to assess the risk of default and determine the appropriate price of
credit. Where historical information about borrowers is available, default pro-
files of categories of lending products and customers can be easily built. Com-
puter technologies have demonstrably increased the capacity, timeliness and
reliability of such systems.
The application of these techniques can now be extended in areas such as
credit reporting. It enables better risk assessment and thus lower cost, by
accounting for all debts owed by a customer and a profile of the customer's his-
tory in meeting such obligations.
In the area of small business loans, the credit assessment process is often sub-
jective and requires substantial security (such as a charge over the family
home). Improved information gathering and processing facilitate better assess-
ment of risk so as to achieve greater effiCiency.
Some lenders in the United States are using proprietary credit scoring
systems to assess risk and monitor small business loans across the country, even
where the lenders do not have branches and where their only contact with cus-
tomers is via mail or telephone. The ability to conduct this type of small busi-
ness lending is based on the use of extensive industry information.
Having learned about the trends and issues involved in electronic banking
and lending in Australia, we will now explain how the technological inno-
vations are shaping the financial services industry in Australia.
comes the Interhet , which partisans are sure can· •.

into profits and, most important, give today's
small business owners the benefits they value
(continued)
James P. PunishHl,online financial service analyst at Forrester Research, has
no doubts about where web-centered lending is headed. In Credit at the
Threshold,an early-1999 study, his team predicted that online lending was on
the threshold of 'hypergrowth', thanks to the combination of willing consumers,
ready lenders and maturing technologies.
In 2003, Forrester predicts, consumers will obtain some nine million loans
and credit cards over the Internet, worth almost $167 billion. Mortgages will
account for the'largest dollar volume: $9].2 billion in 599000 loans, almost
10 per cent of tota19riginations (up from 1.5 per cent in 1999). Close to one
of every six credit cardswill be issued online.
Home equity loans will follow mortgages into hypergrowth. Auto loans will
also begin their move into the Internet. The number of online student loans
will shoot up from twelve thousand to 3.3 million (from 0.1 per cent to 25 per
cent of all such loans).
Forrester's report was based on interviews with more than fifty lending insti-
tutions, among them banks, credit unions and consumer-finance companies. It
was buttressed by discussions with authorities from prominent systems ven-
dors, service bureaus and online credit marketplaces.
Four of every five respondents from lenders said their institutions expected
to be offering credit applications online early in 2000. 'People prefer to apply in
an anonymous manner', one banker said. They don't want to be face to face
a
when they get "No".' The biggest obstacles to online lending at present are the
need for new lending regulations and the assurance of privacy, the lenders said.
How will the Internet change credit markets? Consumers will be more price
sensitive, less loyal, better informed. They will see financial products as commod-
ities. One banker's sobering vision: 'Refinancing will be as easy as watching your
TV and clicking a button to save $53 a month on your mortgage'.
All mortgage websites must offer visitors a choice of rates and loan
online loan application is also a must. Beyond that, three strategic .
to be shaping the future of online lending: 1. How far should you
application while the prospective borrower is still online? 2. Is it better to offer
loans directly to borrowers or through a multilender 'matchmaker' site? 3.
What's the prize: transaction profits or customer relations?
Source: B. Orr 2000, 'Easy money', ABA Banking Journal, April.
Technology-driveninnovation
inAustralia's
financialservices
sector
Australia is one of the few countries in the world that has taken a lead in the
use of technology in financial services. As per the technology progress index,
Australia ranks fifth in the world. These technological innovations are driving
the financial services industry in Australia. The Wallis Report (1997, p. 95)

states that 'innovation driven by new technology is a key factor influencing
change in many industries, including the financial services industry'. It iden-
tifies four areas in which technological innovations are taking place:
• new technology platforms that will have a major impact on financial services
• retail payments and distribution channels
• risk management and data assessment
• the conduct of markets and exchanges.
In the area of new technology platforms, networks and communications
infrastructure are introducing changes in the financial services industry. The
emergence of networks and associated information technologies has profoundly
altered the information and communications landscape. Networks give rise to
pressures for standardisation, interoperability, ease of use and cost-effectiveness.
The Internet and intranets are transforming the operations both within and out-
side organisations. Devices such as public or private access terminals, enhanced
ATMs and enhanced telephones will have greater impact on widening everyday
access to financial services. The Wallis Report (1997, p. 101) quoted a Jupiter
Communications forecast that 'the use of non-PC devices could reach about 16
per cent of Internet access by the year 2000'. Further, smart cards with the
ability to perform identification and information security functions are expected
to facilitate wider access to the Internet. Additionally, Australia's communi-
cations infrastructure is being substantially upgraded via the roll-out of a hybrid
optic fibre and coaxial cable network, which is expected to further boost tech-
nology use in financial institutions.
In the area of retail payments and distribution channels, the use of branches
to conduct retail banking transactions is projected to decline; subsequently, the
use of electronic channels, ATMs, EFTPOS, telephone banking and home
banking is expected to grow. The penetration of EFTPOS and ATM terminals in
Australia can be seen from figure 14.2.
120000
100000
.-. • EFTPOS terminals
0
S 80000
III
iii • ATM terminals
I:
'E 60000
...
40000
20
1991-92 1992-93 1993-94 1994-95 1995-96

FIGURE 14.2 The penetration of EFTPOS and ATM terminals in Australia
Source: Wallis Report 1997, Financial System Inquiry Final Report, Australian Government Publishing
Service, Canberra, p. 101.
As stated earlier, as per the payments statIstICs available at the Australian
Payments Clearing Association website (www.apca.com.au). there were 11 915
ATMs and 362848 EFTPOS terminals in Australia by June 2001.
More sophisticated telephone technology, combined with innovations in its
use by business through both operator-assisted and interactive voice response
systems, is facilitating the increased use of the telephone for accessing financial
services. Personal computer banking, which involves consumers using modem
connections and specially tailored software installed on their personal com-
puters to undertake banking transactions, is set to grow. Internet penetration of
the financial sector is growing rapidly and Internet banking is already showing
its impact in Australia with the success achieved by the Commonwealth Bank.
Electronic cash has been trialled in Australia with the following products:
• Quicklink: a reloadable card, which has been used in Newcastle since 1995
• Transcard: a reloadable card that uses contact-less technology, which is
designed for public transport ticketing
• Visa Cash: a disposable, reloadable card launched in 1995 on the Gold Coast
• MasterCard Cash: a reloadable card, which was on trial in Canberra in 1996.
Another role of networks such as the Internet is to allow customers to compare
the attributes of competing products and to identify the best product. This function
is leading to the development of a new class of information intermediaries called
the intelligent agents. New technologies such as telephone banking and Internet
banking have helped reduce total operating costs, as can be seen from figure 14.3.
100
90
80
......70
60
60
0
(1)
50
a: 40
30
20
10
0
Industry average Industry leader Direct banking Internet banking
Note: Expense ratio is defined by total income (net interest income and no-interest fees).
FIGURE 14.3 Bank expenses ratio, by channel

Source: Wallis Report 1997, Financial System Inquiry Final Report, Australian Government Publishing
Service, Canberra, p. 109.
The new technologies are enabling effective management of financial risk by:
• improving the way in which information can be referenced and accessed
• developing new financial products more rapidly
• identifying risk more easily
• increasing the speed of information flow.

Technology has also helped improve the high-value payment system.
RTGS helps minimise the settlement risk to a great extent. The Wallis
Report concludes that technology is reshaping the financial service industry
and affecting customers, suppliers and intermediaries in the following ways,
among others:
• Infrastructure is lowering the cost of financial services activities.
• Retail transactions are moving towards channels that offer greater
convenience and lower costs.
• Information and risk management activities are facilitated.
• The role of over-the-counter (OTC) and exchange markets is being redefined.
As stated, advances in technology have enabled the delivery of banking and
other financial products to retail and wholesale customers through electronic
distribution channels, which are collectively referred to as e-banking. Along
with the benefits, however, are the risks of e-banking. The issues involved in
managing and regulating risks in e-banking have attracted the attention of cen-
tral bankers around the world.
Regulatoryandriskmanagementissuesin
electronic
bankingandlending
The risk management issues in e-banking, as identified by the Basel Committee
on Bank Supervision of the Bank for International Settlements, can be categ-
orised as:
• the board and management of oversight
• security controls
• legal and reputation risk management.
Theboardandmanagement
The board and management are ultimately responsible for developing a
banking institution's business strategy and approving the provision of
e-banking transactional services. The Basel Committee states that the board
should ensure:
• e-banking plans are clearly integrated within corporate strategic goals
• a risk analysis of proposed e-banking activities is performed
• appropriate risk mitigation and monitoring processes are established to
identify risks
• ongoing reviews are conducted to evaluate the results of e-banking activities
against the institution's business plans and activities
• the operational and security risk dimensions of the institution's e-banking
business strategies are appropriately considered and addressed
• the existing risk management processes, security control processes, due
diligence and oversight processes for outsourcing relationships are appro-
priately evaluated and modified to cover e-banking services.
In practice, however, risk management processes in e-banking pose a con-
siderable challenge to boards for three reasons. First, major elements of the
delivery channel (the Internet and related technologies) are outside the bank's
direct control. Second, services are delivered in countries where the bank may
not have a physical presence. Third, e-banking issues involve highly complex
technical language with which a board may not be familiar. Given these issues,
a board has to ensure it has staff whose expertise is commensurate with the
technical nature and complexity of e-banking applications introduced by the
bank. Further, given that e-banking involves increased reputational risk, careful
monitoring of systems operability and customer satisfaction is required.
Another issue is when a cross-border banking activity is conducted over the
Internet. It potentially subjects banks to increased legal, regulatory and country
risk, given the substantial differences that may exist in licensing, supervision
and consumer protection requirements.
It is also the responsibility of a board to ensure proper security controls and
safeguards are maintained in e-banking systems. Banks must have comprehensive
security policies and procedures that can address potential internal and external
security threats. Boards also have to ensure a comprehenSive and ongoing due
diligence and oversight process is established for managing their bank's out-
sourcing relationships and other third-party dependencies supporting e-banking.
Securitycontrols
Security controls involve several issues, including:
• authentication
• nonrepudiation
• data and transaction security
• the segregation of duties
• the authorisation of controls
• the maintenance of audit trails
• the confidentiality of key bank information.
Banks are required to use reliable methods for verifying the identity and
authorisation of customers. This is called authentication. Unless proper authen-
tication procedures exist, unauthorised persons may be able to access private
accounts. Banks use a variety of methods to establish authentication, such as
PINs, passwords, smart cards, biometrics and digital certificates. When more
than one method for authentication is used, it is called multi-factor authenti-
cation. The Commonwealth Bank of Australia uses a multi-factor authentication
whereby a client wanting to use Internet banking has to enter a client number
and a password to gain access to his/her account.
Nonrepudiation involves creating evidence of the origin and delivery of the
electronic transaction. The purpose is to protect against false denial by the
sender or the receiver. For this purpose, banks issue digital certificates using
public key infrastructure. When a bank issues a digital certificate to a customer,
it establishes unique identification/authentication and reduces the risk of repu-
diation of transaction.

Appropriate segregation of duties is a basic internal control measure used to
reduce the risk of fraud in operational processes and systems. When duties are
adequately separated, fraud can be committed only by collusion. It is possible
to secure access easily if a database is poorly secured, so it is important that
banks emphasise strict identification and authorisation procedures, safe and
sound architecture of the processes, and adequate audit trails.
Authorisation control and access privileges need to be carefully designed.
Failure to provide adequate authorisation control allows individuals to alter
their authority, circumvent segregation and gain access to e-banking systems,
databases or applications to which otherwise they would have no access.
Data integration means ensuring that in-transit information or in-storage
information is not altered without authorisation. E-banking transactions take
place over public networks, so they are exposed to the added threat of data cor-
ruption, fraud and tampering of records. Banks need to have systems in place to
ensure data integration.
For sound internal control, it is important to have clear audit trails of all
e-banking activities. This is particularly important for transactions such as
opening, modifying and closing a customer's account, transactions that have
financial consequences, authorisations granted to overdraw an account, and
transactions to do with granting, modifying and revoking systems access rights
or privileges.
Confidentiality of data stored on the bank's database or transmitted on the
Internet is extremely important. If unauthorised persons can access the data,
then the chances of fraud conSiderably increase. Suitable arrangements need to
be made to avoid breaches of confidentiality
legal andreputational
riskmanagement
Banks have a responsibility to provide their customers with a level of comfort
regarding information disclosures, protection of customer data and business
availability that approaches a level they would have if transacting business
through traditional distribution channels. As part of this process, banks should
make adequate disclosures at their website to allow customers to make
informed decisions. Another important responsibility of the bank is to keep the
data about customers confidential. Violation of this requirement could expose
the bank to possible legal and reputation risk. It is important to make cus-
tomers aware of the privacy policies and relevant privacy issues concerning the
use of e-banking products and services. It is also necessary to ensure the details
of the customer on the bank's database are not used for purposes beyond those
specifically allowed. Another issue is the consistent and timely delivery of
e-banking services, in accordance with customers' expectations. There should
be a contingency plan in the case of denial of service, or in the case of other
events that could cause disruption. Banks also need to develop appropriate inci-
dent response plans, including communication strategies, which ensure busi-
ness continuity, control reputation risk and limit liability
Afuturistic
viewofelectronic
banking
Electronic banking is here to stay. It offers considerable advantages, with the
foremost advantage being the low transaction cost. The suppliers of financial
services will increasingly use technology to gain a competitive advantage.
Boston Consulting Group (1998) predicts that online banking will rapidly
advance in the future, such that hardly a banking activity will be done without
the use of some form of electronic devices. In particular, with the growing
popularity of the Internet, banking online will become the norm. Financial
institutions are already working hard to ensure successful online banking strat-
egies are developed, so as to survive and thrive in a competitive world. This
would require consideration of the following factors:
• building alliances qUickly with other financial institutions, software vendors
and information providers
• effectively outsourcing and, at the same time, building in-house skills
• conducting customer profitability analysis to determine the most profitable
customers, so as to provide broad channels for services and products
• continuing to maintain a central role in payment systems.
Boston Consulting Group (1998) suggests that banks need to pursue the
following three types of strategy:
• Customers' agents. Banks will find that it is hard to achieve economies of scale
due to disadvantages in product manufacturing and processing. As a result,
this production task may be left to others. Similarly, customers will be offered
products from multiple sources and provided with information-integrated
services. Some banks will therefore focus on delivering products produced by
others to customers, acting as customers' agents. A product such as a credit
card, for example, is produced by MasterCard or Visa and marketed by banks
to their customers.
• Product manufacturers. Some banks will focus on product development,
manufacturing and processing, and may position themselves as either a
branded or unbranded wholesaler of product and processing services.
• Integrated players. Some banks who have a strong brand, as well as a strong
position from manufacturing to delivery, may position themselves as
integrated players. Many banks are expected to adopt a hybrid strategy, but
every player in the banking market will need to make a crucial decision
about which areas are strategically too risky to outsource and which
capabilities need to be built in-house.
In sum, although online banking may carry some risks and problems, its
future seems to be bright. Regulators across the world are nevertheless grap-
pling with the safeguards that need to be imposed, and the various risk manage-
ment issues involved need to be considered by every bank offering online
banking.
438 Part6: Currentissues

Summary
1. What is electronic banking and what factors have contributed to its rapid
development?
Electronic banking refers to all banking activities and transactions that
involve the use of some form of technology. The rapid development of elec-
tronic banking was due to two factors. First, because most financial trans-
actions are repetitive in nature, financial institutions found it cost-effective to
deliver services electronically (a supply-side push). Second, the users of
financial services (bank customers) have been equally enthusiastic in their
willingness to adopt technology (a demand-side pull).
2. What were the main stages in the evolution of electronic banking?
Electronic banking and lending has come a long way since its inception
in 1922. The development of the Fed Wire system, ATMs, BACS, SWIFT,
EFTPOS and the Internet can be regarded as the major milestones in
evolution of electronic banking.
3. What are the trends and issues in electronic banking and lending in Australia?
There are two aspects to the trends and issues in electronic banking and
lending in Australia: first, retail financial services and, second, wholesale
financial services. In the retail services, major trends have been: the 1980-85
phase of technology use in Australian banking; the introduction of the trans-
action processing systems technology; the use of technology to handle
front-office branch operations; the use of the Internet for banking trans-
actions; and the use of WAP-enabled mobile phones. Other recent trends
include the use of credit risk assessment models and the use of technology
for data mining. For wholesale banking, the use of financial EDI and the use
of RTGS for payments are key developments.
4. How is technology driving innovations in the financial services sector in
Australia?
Technology is driving innovations in the financial services sector in Australia
in four ways: (1) new technology platforms that will have a major impact on
financial services; (2) retail payments and distribution channels; (3) risk man-
agement and data assessment; and (4) conduct of markets and exchanges.
5. What are the regulatory and risk management issues in electronic banking
and lending?
The regulatory and risk management issues that apply to electronic banking
and lending have been classified by the Basel Committee in three categories:
(1) the board and management of oversight; (2) security controls; and
(3) legal and reputation risk management.
6. What does the future hold for electronic banking?
The Boston Consulting Group (1998) found that online banking will rapidly
advance and that hardly a banking activity will be done in the future without
the use of some form of electronic device. With the growing use of the Internet,
we expect that most financial and lending services will be delivered via websites.
APCS, p. 419 data integration, p. 437 RTGS, p. 419
ATM, p. 416 EDI, p. 418 stored value cards, p. 414
authentication, p. 436 EFTPOS, p. 415 SWIFT, p. 416
BACS, p. 416 nonrepudiation, p. 436 value added network,
BECS, p. 419 PIN, p. 418 p.418
CHAPS, p. 416 RITS, p. 419 WAP, p. 420
Discussion
questions
1. Briefly outline the history of electronic banking.
2. What were the two major reasons for the growth of electronic banking?
3. What are the various ways in which technological developments are
reshaping the financial services industry?
4. What three phases of technology development in the retail financial ser-
vices industry were identified by Anderson Consulting?
5. Is technology useful for the lending activities of banks? If so, explain
with examples.
6. What do you understand by the term 'relational technology'? What role
does it play in the financial services industry?
7. What are legacy systems? Are they corporate assets or a financial
burden?
8. What are the various uses of EDI in the financial services industry?
9. Outline the emerging role of banks in e-commerce.
References
andfurtherreading
Andersen Consulting 1987, Trends and Issues in Retail Financial Services
Technology, Sydney.
Basel Committee 1999, Payment Systems in Australia, Bank for International
Settlements, Basel.
Boston Consulting Group 1998, www.bcg.com.
Bryant, G. 2000, 'Deals on the run', Business Review Weekly, 13 October, pp. 98-100.
Campbell Committee Report 1981, Australian Financial System: Final Report of the
Committee of Inquiry into the Australian Financial System, Australian Financial
System Inquiry, Australian Government Publishing Service, Canberra.
Deakin, M. & Goddard, C. 1994, 'Electronic banking: background and history', in
Electronic Banking and Security: A Guide to Corporate and Financial Managers,
eds B. Welch, Blackwell, Oxford.
Dempsey, S. 2000, 'E-devices get a move on', Business Review Weekly, 13 October,
pp.102-3.

Ferguson, A. 2000, The mobile shake-out', Business Review Weekly, 22 September,
pp.58-61 .
Ferguson, R. W. 1998, 'Electronic banking: where are the customers? What do they
think? What does it mean for the Federal Reserve?', BIS Review, 78, p. 1.
Gibbons, P. 2000a, 'A bank in the hand', Business Review Weekly, 13 October, p. 107.
Gibbons, P. 2000b, 'WAP bides its time', Business Review Weekly, 8 September,
p.76.
Hannen, M. 2000, 'The on-air airlines', Business Review Weekly, 13 October, p. 108.
Hendry, M. 1993, Implementing EDI, Artech, Boston.
Kennedy, 0.2000, 'Mobile net feels a need for a speed', Australian Financial Review,
29 November, p. 11.
KPM G 1998, Home Internet Banking Survey, Sydney.
National Office for the Information Economy 2001, The Current State of Play,
Canberra.
National Office for the Information Economy 2002, The Current State of Play,
Canberra.
Wallis Report 1997, Financial System Inquiry Final Report, Australian Government
Publishing Service, Canberra.
Weaver, P. M. & Shanahan, K. M. 1994, Banking and Lending Practice, Serendip
Publications, Hornsby, New South Wales.
Wenninger, J. 2000, The emerging role of banks in e-commerce', Current Issues in
Economics and Finance, Federal Reserve Bank of New York, 6(3), pp. 1-2.
Introduction
Over the years, particularly after deregulation of the financial sector, the man-
agement of commercial banks has become increasingly challenging. According
to KPMG (2000), the challenges include shrinking margins due to competition,
the threat of new entrants, newer distribution channels made available by
technological innovations, and globalisation. The area of customer management
has become particularly challenging. The Wallis Report (1997) also found that
customer management has become increasingly important. The report stated
that the financial services landscape is undergoing change to keep pace with
change in the financial needs of customers. The changes in demographic and
workforce patterns, among others, are affecting the channels through which
financial services are distributed, the financial products on offer and the sup-
pliers of financial services. Competition in the financial services market and
customers' willingness to use a number of providers for their financial services
needs are making it harder for market participants to attract and retain cus-
tomers. Customer management strategies have thus become the focus of man-
agements of financial institutions. These strategies aim to maximise the
profitability of existing customers, attract new customers and influence the
behaviour of unprofitable customers so they go elsewhere or use low-cost distri-
bution channels.
Against this background, understanding the needs of customers through
appropriate data management, designing profitable product packages and
marketing those products to clients have become more important. Pressures are
mounting for a more effective marketing management of financial services
offered by the banks. In this chapter, we will discuss the role of marketing in
financial institutions, the various elements of marketing, how marketing strat-
egies and goals are decided and what makes some financial institutions more
successful than others in the marketplace. This chapter draws on the work of
Channon (1988). For more details, see Channon's original work (as sourced in
the 'References and further reading' section at the back of the chapter).
Roleofmarketing
infinancialinstitutions
Reekie (1972, p. 56) defines bank marketing as 'that part of management
activity which seems to direct the flow of banking services profitably to selected
customers'. We notice two essential elements of financial services marketing
from this definition: first, marketing is directed to selected customers and,
'>econd, such an effort must be profitable. To achieve these two goals, it is
necessary to follow the marketing approach to the provision of financial ser-
\ices. The distinguishing feature of such an approach is that it is customer cen-
t ric. According to Meidan (1984), such a customer-centric approach involves
essential steps:
<..,i:-.:
I. Identify the customers' financial needs and wants.
2. Develop appropriate banking products and services to meet customers' needs.
3. Determine the prices for the products/services being developed.
4. Advertise and promote the products to existing and potential customers of
financial services.
S. Set up suitable distribution channels.
6. Forecast and research future financial needs.
It consists of asking questions such as 'Who will buy our services?', 'How will
the environment affect us?', 'What are the elements of the marketing mix?',
'What resources do we need?', 'How will we implement the plan?', 'Who is
responsible for each action step?' and 'How will we control and revise the plan?'.
This process requires the preparation of a marketing plan, implementation of
the plan, monitoring of the outcomes and the making of suitable changes to the
strategy. The marketing plan is never prepared in isolation; it is one part of an
overall corporate strategic plan. The marketing plan of a financial institution is
similar to that of other industries but with Significant differences in the way in
which the marketing strategies are developed and the marketing mix is decided.
Meidan (1984) states that banking serves and products are intangible. These
products and services satisfy a general need rather than a specific need. To make
the benefits of their services more apparent, banks need to effectively relay their
promotional messages to prospective customers. Marketing plans therefore need
to be prepared with great care.
A typical financial institution considers the following matters when preparing
a marketing plan:
• market analysis (competitor analysis)
• analysis of retail banking needs (consumer needs analysis/purchasing
financial services)
• analysis of wholesale banking needs (planning of a corporate account
strategy)
• a product development and marketing strategy
• a product pricing strategy
• a delivery system strategy
• a communications strategy.
In the following sections, we will discuss each of the above aspects.
Marketanalysis
Market analysis begins with defining the market. Channon (1986, p. 14) defines
the market as 'an intersection between a class of customers and a bank product
or service group'. It is not possible for a smaller bank to offer every type of
product needed by a customer, so it is usually necessary for smaller banks to
define the market. Bigger banks, which are 'universal banks', can cater to most
customers' needs. Smaller banks usually operate in a subset of the total market.
In Australia, banks such as the Bank of Queensland serves a subset of the total
market (the State of Queensland), while the Commonwealth Bank of Australia,
for example, operates in the national market.
I 444 ParI 6: Currentissues I

Besides classifying markets on a geographic basis (that is, regional or
national), we can classify them on the basis of the clients served. Where a finan-
cial institution serves predominantly personal clients, we say that it is operating
in the retail market; when it serves corporate clients, we say that it is operating
in the wholesale market. This distinction between retail and wholesale markets
is not watertight and banks are often found operating in both (or some parts of
both) markets. The market analysis of the wholesale (corporate) market and the
retail (consumer) market is done differently, because the needs of the clients in
these two markets are different. In the following sections, we will discuss how
this analysis is conducted.
Screening
thewholesaleorcorporate
market
The screening of the corporate market can be done using the following market
segmentation variables:
• Turnover. Some banks may not pursue corporate accounts with turnover less
than, say, $10 million, $50 million or $100 million. Turnover is the widest
used single segmentation variable. It is more appropriate to use this variable
along with a combination of other variables.
• Geographic cluster. Corporate accounts tend to be geographically clustered.
In Australia, most corporate accounts are clustered in Sydney and
Melbourne.
.. Industry classification. It is important for financial institutions to know the
specific financial needs of key industries. The financing needs of a firm in the
aviation industry, for example, could be very different from the needs of a
firm in the food processing industry.
• Analysis of the existing bank. The key strengths of the competitor bank that is
already serving the financial needs of the corporate customer need to be
analysed. This will help the bank decide what strategy needs to be adopted so
as to win over the client.
• Gaining a foothold in a subsidiary company. Many large organisations have
subsidiary companies. A bank can try to gain a foothold in a newly formed
subsidiary and work its way up to the parent company.
• Number of employees. The number of employees, the value added per
employee and the capital employed per employee are some indicators of
organisation size. Many banks offer special interest rates to employees of
certain organisations to gain a foothold in the company and eventually
penetrate its accounts. The Commonwealth Bank of Australia, for example,
offers lower interest rates on home loans for university staff.
• Level of exports and number of overseas offices. The proportion of exports to
total sales could be an indicator of the export finance needs of that
organisation. Bank marketing can then be structured to address these needs.
Similarly, the number and locations of overseas offices are other indicators of
the level of multinational activity of an organisation.
• Asset composition. Analysis of the composition of a company's assets can help
a bank identify the company's possible financial needs, so as to suitably target
the marketing effort. By analysing the current assets and current liabilities,
for example, the bank can calculate the company's working capital
requirements and suggest specific banking products, such as factoring and
overdraft lending. Similarly, by analysing fixed assets, the bank can know
whether there is a need for long-term capital finance or leasing finance.
Screening
theretailmarket
The following variables help in subgrouping the retail segment of the market:
• High-income segment. Customers that have a high net worth (worth exceeding
$1 million, say) have special types of financial need. These customers are a
source of low-cost deposits and represent attractive prospects for large loans.
Some banks may establish a lower cut-off (say, $100000 or more) to segment
this type of customer.
• Professionals and self-employed. This group includes doctors, lawyers,
architects, accountants and other such professionals. These groups are
potential clients for small business loans. Self-employed customers are
attractive as potential purchasers of loan products, although generally are
considered 'risky' by the banks. This group can include persons such as
mechanics and hairdressers.
• Students and senior citizens. Students represent a growing market segment in
retail lending. 'Catch them young' is the slogan widely used in banks. It is
based on the premise that if the financing needs are met at the education
stage in life, then the student will remain loyal to the bank over time. Senior
citizens, on the other hand, represent a group that has surplus funds. The
bank may be able to sell investment products (rather than lending products)
to this group.
According to Stemper (1990), retail market analysis involves three basic
steps: understanding the needs of the customer, defining their needs and ana-
lysing the opportunities.
Understanding
customers
Several demographic factors - such as age, income, education, occupation,
marital status and number of children affect the customer demand for financial
services. The Wallis Report (1997) identified the changing demographic factors
in Australia. It states that changing demographics are having a profound effect
on customer needs and that these changing customer needs will have impli-
cations for distribution channels, products and supplier choice. According to
the Wallis Report, the following are the key changes in demographics:
• By 2021, almost 17.5 per cent of the Australian population will be over
65 years of age, which would mean an increasing demand for superannuation
and retirement products. As the Commonweath Government encourages
reduced dependence by retirees on age pension, there is a resulting shift in
household financial assets into market-linked investments. As customers

invest more in market-linked secuntres, the demand for the financing of
those investments and the management of investment portfolios will
increase. Loans to finance investments in securities are becoming a growth
area for banks, requiring the marketing of these types of loan product.
• Work patterns are changing, with more people working extended hours. The
educational levels in Australia are also increasing. About 15 per cent of
Australian workers in 1996 held a graduate or higher qualification, compared
with 10 per cent in 1986. The percentage of workers holding a diploma or
other trade qualification, however, was constant over this period (at
approximately 30 per cent). The Wallis Report estimated that this could lead
to a demand for loan products that have more smooth cashflows - for
example, student loans and home loans with variable repayment and redraw
options.
Further, since those in employment generally have less time, they will opt
for products that offer convenience and ease of access. Loan products that
can be easily accessed over the Internet will be in greater demand.
• Another trend noticed in the Wallis Report is that the financial assets of the
household sector are growing at an average rate of 7.7 per cent. This growth
in assets is being financed through bank loans. Nearly three-quarters of
household indebtedness is financed out of bank loans, highlighting the need
for increased efficiency in banks' delivery of loan services.
• . Consumers will seek products and suppliers that offer best value. In
particular, consumers are becoming more price sensitive to transaction fees
and interest rates on financial products such as loans. This increased value
awareness is likely to drive the competitiveness in the financial sector
further. The Internet has already emerged as a tool for financial product
comparisons.
• The Wallis Report found evidence of customers' increasing use of new
financial services technologies. This use has a direct effect on the way in
which financial services are delivered.
Innovations in technology could help banks understand customer needs.
Techniques such as data mining can help determine the profile of customers
most likely to buy a particular loan product. This enables targeting of marketing
programs to a particular segment of customers; that is, only information that is
relevant is sent to customers, saving customers time in sifting through the
information. Financial institutions can highlight prominently the products that
may suit a particular customer group, saving marketing costs by sending cus-
tomers only relevant information. Technology can also help in credit risk
assessment. Credit risk models that assess the risk of default and determine the
appropriate price of credit are now determining the competitiveness of lending.
In the area of small business lending, some lenders in the United States are
using proprietary credit scoring systems to assess risk and monitor small busi-
ness loans. These systems require extensive gathering of information, which is
facilitated by technology.
The Wallis Report found that changing customer needs are an important
drive of change in the finance industry. A financial institution that desires to
succeed needs to sense these changing customer needs and determine how it
can best meet customers' price, service and delivery expectations. It has to
account for these changes while designing a marketing strategy for loans and
other products.
Definingcustomer
needs
Stemper (1990) states that defining customer needs involves building a com-
plete inventory of the financial service needs of the customer. It involves asking
questions such as 'What are the needs of the customer?" 'How many of these
are already satisfied?', 'How well are they satisfied?' and 'How many are yet to be
satisfied?'. There is also a need to understand how a customer trades off one
financial need for another. The data gathering of customer preferences is a
market research task. The value of the data gathered depends on the process of
data collection. It is important that financial institutions ask specific questions
on pricing and fees, so they can establish the profit being generated from that
customer.
Based on all the services that a customer uses, financial institutions can cal-
culate the revenue that a customer generates, the expenses incurred to service
the customer and the profit margin available. Once this information is at hand,
the importance of the customer to the institution is known and the bank can
target lending products and other services accordingly.
Analysing
opportunities
After customer data are gathered, the next step is to match the customer needs
with products and services provided by the financial institution. Where the
needs and products offered are standardised, a catalogue of products on offer
could be sent to the customer. Financial institutions are increasingly using the
Internet to reach customers, but the traditional marketing methods are not
unimportant. Where customers' needs are fairly complex, these can be broken
down into subcategories, and the products that satisfy a particular category can
then be marketed to the customers.
Stemper (1990) states that this step involves asking questions such as 'What
is the need?" 'How can we satisfy the need?', 'What is the pay-off?' and 'What
crucial questions need to be asked so new products can be conceived to meet
customer needs profitably?'.
Analysing
market/industry
charateristics
Once the initial screening of retail and corporate market is complete, or even
while the screening is being conducted, an assessment of the following markeU
industry characteristics is necessary.
Market characteristics
Assessment of the market characteristics involves finding the following information:
• What is the market size?
• What are the historical growth rates?
448 Pari 6: Currentissues

• What is the projected growth rate?
• How does the buying decision process take place?
• What are the service use characteristics?
• How does the service delivery process work?
• What are the financial characteristics of customers?
• What is the number of accounts in total?
• What is the number making up 50-80 per cent of the market?
• What is the trend in market concentration?
Service characteristics
Assessment of service characteristics involves finding the following information:
• What is the value added?
• What is the degree of service differentiation?
• What is the relative capital intensity?
• Is there a potential for cross-selling?
• What will the impact on shared cost structures be?
• Are there possibilities for service integration with other bank services?
• What is the level and type of risk to the bank?
• What is the relative profitability of the service?
• What is the rate of service changelinnovation?
• What are the details of add-on service characteristics?
Competitive characteristics
Assessment of the competitive characteristics involves identifying:
• the bank's market share and relative share
• changes in the number of competitors
• trends in market share
• major competitors and their market shares (including nonbanks wherever
relevant)
• the degree of competitor concentration
• relative service cost
• relative capital intensity
• relative market effort
• relative service quality (assessment of the full concept of the service,
including delivery, time, accuracy and so on)
• relative resources availability
• relative systems capability
• barriers to entry or exit
• relative service price
• relative delivery system capability (including network size and coverage,
account officer's skill and so on)
• relative employee skills.
Environmental characteristics
Assessment of the environmental characteristics involves identifying:
• political, economic and social trends, and their impact on the market
• trends in technology and their impact.
Some trends in the context of Australia have already been discussed.
By knowing what the customer needs, defining the need, analysing that need
and matching it with products already available and those that could be made
available, a financial institution can be competitive in the lending market.
SWOTanalysis
Once the above data are collected, indicating the bank's market and the relative
position of the bank, the bank conducts a SWOT analysis (that is, an analysis of
its strengths, weaknesses, opportunities and threats). A useful format that can
be used to carry out the SWOT analysis is reproduced in figure IS.1.
Cross-impacts
Present Opportunities Threats Future
Strengths 1 2 3 4 5 1 2 3 4 5 Opportunities
1. Bank network ++ ++ ++ ++ ++ 10 1. Project finance

2. Service quality + - ++ + ++ 5 2. Global cash
management
3. Lending power ++ 0 0 + ++ 5 3. Global HNWI*

banking
4. 4.
5. 5.
Weaknesses Threats
I I
1. Systems - = 0 = - -6 1. Foreign bank
capability threats
2. Geographic = = - - = -7 2. Nonbank
organisation competition
3. 3.
4. 4.
5. 5.
2 -2 3 1 3 7
*HNWI = high net worth individuals

FIGURE 15.1 Bank SWOT analysis
Source: D. F. Channon 1988, Bank Strategic Management and Marketing, John Wiley & Sons,
Chichester, p. 29.
I 45D Pari6: Currentissues I

SWOT analysis is extremely useful in identifying and assessing the stra-
tegic situation faced by the bank. Bank executives may be asked to priori-
tise what they consider to be the bank's key strengths and weaknesses.
Analysis of opportunities can help identify ways in which to realise these
opportunities. Similarly, strategies can be identified to combat the key
threats. Ennew, Watkins and Wright (1991, p. 72) state that 'effective
SWOT analysis does not simply require categorisation of information; it
also requires some evaluation of the relative importance of various factors
under consideration'.
After the SWOT analysis is complete, it is compared with the present strategy
of the bank to identify areas needing action. In addition, measures of the com-
petitive position of the bank are analysed. These include competitive position
measures such as:
• relative service quality
• relative price
• customer concentration
• absolute market share
• relative share measured as a percentage of the combined share of the bank's
largest three competitors
• trend in the market share
• the relative capital intensity of the bank as a percentage of that of the bank's
three largest competitors (noting that a higher capital intensity is usually a
weakness)
• relative profitability
• the rate of service innovation (the percentage sales from new products
introduced in the previous three years).
The next step consists of assessing the relative attractiveness of each market
in which the bank is doing business. The market attractiveness measures iden-
tified by Channon (1988) include:
• the size of the market
• the past growth rate
• the projected growth rate
• the number of competitors
• competitor concentration
• market profitability
• the degree of product differentiation
• the level of capital intensity
• relative customer power
• the trend of profitability and market fit.
After the above analysis is carried out, the relative pOSItIOn of each bank
activity is identified. For this purpose, the competitive position/market attrac-
tiveness matrix in figure 15.2 (page 452) may be useful.
Strong Competitive position Weak
High Growl Growl Harvest!

balanced penetrate restructure!
rebuild
Defend! Selectively Withdraw

invest invest! gracefully!
segment seek
niches
Harvest Withdraw Exit fast!

gracefully use as
attack
Low business
FIGURE 15.2 Bank strategic market portfolio
Source: D. F. Channon 1988, Bank Strategic Management and Marketing, John Wiley & Sons,
Chichester, p. 37.
The last, but not least important, step in market analysis is the analysis of
major competitors (see, for example, figure 15.3). In the Australian context,
competition in the banking market has considerably increased as a result of
deregulation and the entry of foreign banks and nonfinancial companies into
the banking business. The home loan market is a case where mortgage
managers/originators have posed a significant threat to established banks. To
analyse who the major competitors are, what their strategies are and what
their strengths and weaknesses are, some banks have developed a competitor
intelligence system. Such a system analyses competition at two levels. At the
corporate level, all the major players (national and international) are con-
sidered for analysis. Banks such as the National Australia Bank would con-
sider the competition posed by the major Australian banks as well as foreign
banks (say, CitiBank). Similarly, in the international market in which the
bank operates (the United Kingdom, for example), the analysis has to
account for competition from the major banks in that country. At the local
market level, however, competitors are usually the local banks. In a town
such as Toowoomba, a bank has to compete with regional banks such as
Bank of Queensland and Suncorp Metway.
While identifying competitors, the bank examines those that are having, or
are likely to have, an impact on its strategy and plans. Existing direct competi-
tors, new likely competitors and potential new entrants are thus analysed. The
information about competitors can be collected from their annual reports,
product literature, financial press, papers and speeches of corporate executives,
reports from customers, stock brokers and professional advisers. Some banks
also appoint retired executives of competitor banks as their consultants, to gain
'inside' information about their competitors in specific areas.

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Local cheque accounts

Local deposit services
Local overdraft
Local term loans
Acceptance credits
Export finance
Import finance
Standby LCs
Foreign drafts
Local collections
Local leasing
Local factoring
Cash management services
Treasury advice services
Credit card services
House purchase loans
Investment advice
Trustee services
ii
International currency lending
Loan syndications
International investment advice
Mergers and acquisitions
Foreign trade services
tt
Project finance
Foreign exchange services
Bonds and private placements
ctl
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,
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Buyer credits i
Construction loans
Venture capital
Computer services
Machine banking
H
FIGURE 15.3 Customer needs/competitive position matrix
Source: D. F. Channon 1988, Bank Strategic Management and Marketing, John Wiley & Sons, Chichester, p. 105.
For evaluating the strengths and weaknesses of competitors, data collection is
extremely important. The necessary information includes basic data (such as
the number of staff and the number of offices) and financial data (such as
deposits and advances, market share by segment and by geography, major cus-
tomers served, key suppliers and key individuals). Once such data have been
gathered, the bank can analyse competitors' marketing strategy, operational
strategy, financial strategy and product development strategy.
New techniques have been suggested in recent years to measure the competi-
tive position of a financial institution. Reidenbach et al. (1995) suggest that
banks should examine the different product/markets in terms of their capacity
to produce a differential value advantage that will translate into superior perfor-
mance. They have developed two tools - a value matrix and a vulnerability
index - that enable a financial institution to identify potential value-creating
opportunities, the means of achieving them, value attributes in which the bank
is vulnerable and the competition's points of vulnerability.
Finally, the marketing plan for each of the segments (retail and corporate) is
identified and these plans are later integrated into divisional, departmental and
corporate strategic marketing plans.
Analysisofretailbankingneeds
Given that services and products offered by financial institutions are ultimately
received or demanded by customers, analysiS of customers' needs becomes an
important aspect of an overall marketing strategy. Independent research con-
ducted by the Finance Sector Union of Australia (2001) showed what Australian
customers want:
Independent community research reveals what bank customers want.
• Loyalty to customers
• More personal contact with tellers
• Higher standards of service
• Less pressure to use electronic banking
• Special consideration for people in need
• Lower fees
• Give something back to community
• A social charter for banks
• Stronger government regulation of banks
The research has confirmed that customers' issues are also [the banks') issues. It
looks like customer service, jobs and branch closures [are 'hot issues').
We have already considered the changing needs of consumers as identified by
the Wallis Report. Here, we will consider how to conduct a consumer need analysis.
Consumer behaviour is influenced by a number of factors. These include
cultural, group, personal, social class and organisational factors.
• Cultural factors. Culture does not grow overnight. Attitudes that may seem
absurd in one culture may be perfectly reasonable in another culture. Culture
influences attitudes towards risk, competitiveness, individualism and so on.
Ethnicity and religion are among the cultural factors that affect individual
behaviour.

• Group factors. Individuals belong to certain groups, such as professional
associations and trade associations, which also influence their attitudes.
• Personal factors. These include age, stage in the lifecycle, occupation and
lifestyle.
• Social class factors. The social stratum to which a consumer belongs also
influences his/her behaviour. The financial needs of lower classes are mainly
for consumption, while those of upper classes are for investment.
• Organisational factors. In the case of corporate clients, their organisation
culture needs to be studied.
Table IS. I explains the buying decision-making process and the various
factors that influence the buyer decision.
TABLE 15.1 Stages in bank customers' decision-making process
Stage Informationrequired Meansbywhichbankscaninform
Cognitive balance Comparative position information Promotion, personal communications

Cognitive imbalance Demonstrative information Advertising, word of mouth
Awareness Alertive information Advertising
Information search Relevant information Advertising, promotions
Knowledge Detailed information Brochures, personal communications
Evaluation behaviour Comparative information Advertising, word of mouth
Preference Comparative information Advertising
Decision Contractual information Personal communication
Post-purchase Continual information Advertising in mass media
Source: A. Meidan 1984, Bank Marketing Management, Macmillan, London, p. 30.
Analysisofwholesalebankingneeds
The area of corporate banking is challenging for many banks. In this area, the
domestic banks have to face competition from foreign banks, particularly in
Australia. Given their nationwide branch network, domestic banks have little to
fear from foreign banks in the retail banking areas, but the case is otherwise in
wholesale banking. A few large accounts make a substantial difference to the
overall business of a bank, so the banks are usually interested in winning big
corporate accounts.
Before canvassing a corporate account, a bank needs to screen important data
about the account. A review of basic financial data, ensure it is consistent with
bank exposure and risk requirements, is essential. It is also necessary to calcu-
late the effect on bank profitability that the account will have. A review of basic
financial data involves reviewing the trend in sales, profits, current assets and
current liabilities, fixed assets, overall liquidity, net worth and other such
factors. Ratio analysis and credit rating reports from agencies such as Dun &:
Bradstreet may help. General data on the number of employees, major
shareholders, market position, brand names, the names of the board of directors
and other key staff, for example, also may help.
Other data that may be useful include industry data. The growth rate of the
industry in which the firm operates, the competitive environment within the
industry, and the capital and market intensity of the industry are some factors
that need to be studied. Similarly, data regarding the existing lead bankers, other
bankers, accountants, consultants and solicitors used could be useful for analysis.
After analysis of data, the next step is to identify those accounts that the bank
would like to contact on a priority basis. The purpose of the contact is to
understand the needs of the client. It involves asking questions such as 'What
banking services are required?', 'What is the expected use of any financing?',
'Which bank is presently supplying the service?', 'How does the customer rate
that bank's service?', 'What are the strengths and weaknesses of the competi-
tors?', 'Who makes the banking-related decisions in the organisation?' and
'Which of the bank's services could best suit this client?'.
Studies of multinational corporations in the United States and Europe
showed that having a global branch network and having officers who are
knowledgeable in international services were the multinational corporations'
two top reasons for choosing a bank. Tables 15.2 and 15.3 show the factors that
corporate clients and middle market organisations consider when choosing a
financial institution for financial services.
TABLE 15.2 Criteria used by multinational corporations in selecting lead banks
European
USmultinational multinational
corporations corporations
Criterion (%) (%)
Have global branch network 57 44

Have officers knowledgeable in international services 34 n/a
Have as domestic lead bank 32 24
Are efficient in international operating services 28 46
High high-quality forex services 27 49
Provide most foreign credit needs 26 21
Have outstanding specialists in wide range of 24 nla
international services
Have ability to meet multicurrency borrowing needs 21 n/a
Are competitive in pricing international credit services 19 38
Are efficient in international money transfer services 19 26
Have strong reputation among foreign governments and 13 n/a
banks
Have strong international cash management services 9 12
n/a Not available

Source: © Greenwich Research Associates, cited in D. F.Channon 1988, Bank Strategic Management
and Marketing, John Wiley & Sons, Chichester, p. 85. Data collected in 1988.

TABLE 15.3 Factors in the choice of a principal bank
Proportionsaying
'veryimportant'
(%)
Can provide most services 79

Are price competitive on loans 76
Understand our needs and problems 70
Are fast on processing transactions 50
Are flexible in tailoring services 50
Are price competitive on forex 36
Are efficient in international money transfers 29
Are knowledgeable about our industry 20
Have global branch network 21
Knowledgeable about wide range of international services 19
We have used them before 17
Source: Centre for Business Research, cited in D. F. Channon 1988, Bank Strategic Management and
Marketing, John Wiley & Sons, Chichester, p. 95. Data were collected in 1998.
Account analysis and marketing planning help to systematically win over big
corporate accounts, and are an essential part of any wholesale banking strategy.
Product
development
andmarketing
strategy
The products of financial institutions are essentially the services they offer.
According to Meidan (1984), there are three purposes of product development:
0) to attract customers from outside the present market, (2) to increase sales to
the existing market (by increasing cross-selling, attracting core accounts from
competitors and developing products for sale to competitors' customers inde-
pendent of the core account) and (3) to reduce the cost of providing an iden-
tical or similar service. The process of product development goes through five
stages: generation of an idea, business analysis, technical development, pilot
testing and commercialisation. All new products pass through these six stages.
New product ideas are generally developed by using external sources (such as
specialist new product development agencies), learning from overseas or simply
copying competitors. Davison, Watkins and Wright (989) found that copying
from competitor's ideas was a major source of new product development in the
financial services sector.
Financial institutions offer a wide range of lending and credit products,
including:
• overdrafts
• project finance
• syndicated loans
• mortgage finance
• term loans (whether short term, medium term or long term) against various
types of security
• finance for imports and exports
• leasing, factoring and hire purchase finance.
Studies in the United States and Europe showed that performance letters of
credit, euro currency lines of credit and euro currency medium-term loans were
the top three credit services used by multinational corporations. It is important
that bank staff are familiar with the bank's products and their features compared
with those of competitor banks. This knowledge will help staff recommend the
most appropriate service to clients.
In the area of retail lending, real estate lending is particularly important in
the Australian context. At the Bank of Queensland, for example, real estate
lending constituted more than 50 per cent of the total loans and advances in
2000. Real estate lending offers many advantages to a bank. The lending is rea-
sonably safe and secure, with a lower degree of default compared with, say,
business loans. It also has advantages for capital adequacy purposes. The risk
weight of mortgage loans is half that for business loans. No wonder the compe-
tition in this sector is high.
Another area of competition is the credit card market. A credit card rep-
resents a clean loan given by a bank. The interest rate on credit card loans
is very high, so it is a profitable lending area for a bank. All the major
banks in Australia have presence in the credit card market. Debt out-
standing on bank-issued credit cards has significantly grown. The details of
the amount committed and the amount used under credit cards in Australia
have already been discussed in chapter 5, 'Consumer lending'. Banks issue
two types of credit card: one with an interest-free period (with an annual
fee) and one on which the outstanding balance accrues interest almost
immediately (without an annual fee). Growth in credit card debt has been
concentrated in credit cards with an interest-free period, suggesting that
users are not seeking longer term finance to make purchases, but rather are
using credit cards as a medium simply to make payments. The income for
the bank is from the fees and interest charged on credit cards. The greater
use of credit cards to make payments is due to incentives available under
loyalty and other reward programs, the convenience of being able to make
payments over the telephone or Internet, and the desire to minimise the
impact of fees charged by banks on transaction accounts. Banks should
account for these factors while devising strategies to acquire a larger share
of the market.
Banks and some investment brokers also promote margin lending facil-
ities to enable individuals to finance the acquisition of shares for invest-
ment. A survey conducted by the Reserve Bank of Australia revealed that
margin loans in Australia totalled $4.2 billion at the end of 1998 - double
the amount of margin loans identified in a similar survey conducted in
1996. Margin lending is a relatively risky form of lending but still offers
opportunities for the banks to expand their business. Technology has
enabled trading over the Internet; as a result, banks that are not offering
this facility to their shareholders may find it hard to push into the margin
lending market.
458 ParI6: Currentissues I

Other than the above consumer loans, the following areas of finance are
growing:
• Leasing. This has been found to be an area of significant growth in recent
years, because it provides the bank with a superior rate of return over that
obtained on conventional lending. Leasing offers substantial opportunities to
tailor products to a customer's need. It is generally organised through a
separate division of the bank.
• Projectfinancing. This is another area that offers opportunities to the banks to
expand business. The finance company arm of the bank generally handles
activities such as leasing, project financing and factoring. Banks are also
taking an interest in venture capital financing, and many have specialised
outfits that provide advice, consultancy and finance to venture corporations
(especially to those engaged in high-technology areas).
To capture a larger share in the loan market, it is important that bank officers
have sufficient knowledge of the products offered by the bank and their
features. For this purpose, banks need to provide staff with regular training and
briefs. Banks usually prepare a gUide or manual of products and services for
bank staff. The guide should provide the key points that staff should emphasise
to the clients. Similarly, it should also contain frequently asked questions and
standard responses. Banks now provide most of these guidelines to staff via an
intranet. A useful checklist for screening of new banking and financial products
is reproduced in figure 15.4.
1. Can the servicebe marketedthrough the existingdeliverysystem?

2. Is the servicehard to imitate?
3. Will the serviceassist in buildinggood customerrelationships?
4. Is the selVicecompatiblewithcQrporateimage?
5. Is servicequalHyeasily maintained?
6. Is servicecompatiblewith existingskills?
7. the service compatiblewith resourceavailabilities?
8. Is there the to build a strongbase in the relevant
marketse e
Is
FIGURE 15.4 xample of a first-phase screen for development of a new product

Source: nnew 1991, 'Product strategy', in Marketing Financial Services, eds nnew, Watkins
& Wright, Butterworth-Heinemann, Oxford, p.
and we that
to us
nnnronc ,Berinson
we had women I had
and I've feIt they have been putting the knife into me half
and
Source: M, Dobbie 1998, 'Mortgage Bank of the Year', Persona/Investment, July, p, 54,
management is all about knovving the customers

Customer relationship )
the institutions, The
'CRM' has the huzz in
over
the
economic unrest'
product
that the state
financial institutions view CRM,
is in the United insti-
tutions are very focused on front office and on
UUJ,HH,r;customers.
2. What is the role of marketing in lending and other financial services?
Marketing decisions guide all the operations of a financial institution. They
involve asking who will buy the bank's services, how the environment will
affect the bank, what the elements of the marketing mix are, what resources
are needed, how the plan will be implemented, who is responsible for each
action step and how the plan will be controlled and revised.
3. What are the elements of a marketing plan in financial institutions?

The various elements of a marketing plan in financial institutions are market
analysis (competitor analysis); the analysis of retail banking needs (con-
sumer needs analysis/purchasing financial services); the analysis of wholesale
banking needs (corporate account strategy); a product development and
marketing strategy; a product pricing strategy; a delivery system strategy; and
a communications strategy.
4. What is market analysis and how is it done?

Market analysis involves deciding the market size, calculating the organ-
isation's market share and undertaking competitor analysis. It begins with
defining the market: analysis of the wholesale (corporate) market and the
retail (consumer) market is done differently because the needs of the clients
in these two markets are different.
5. How is a retail banking strategy planned and implemented?

A retail banking strategy is a part of the overall marketing plan of the finan-
cial institution. It involves defining what the customers want and how best
the needs of the customers can be met. By implementing the marketing plan,
the bank makes its strategy operational.
6. How is a wholesale banking strategy planned and implemented?

A wholesale banking strategy is planned and implemented in a similar
manner to a retail strategy. The only differences are the clientele and the
approaches needed to meet their needs.
7. How are financial products developed?

The process of product development goes through five stages. These are
generation of an idea, business analysis, technical development, pilot testing
and commercialisation. All new products pass through these five stages.
8. How is the pricing strategy decided?

The pricing strategy of a bank is a function of three key determinants:
demand, the prices charged by competitors and the underlying cost struc-
ture. Determining a pricing strategy involves conSidering these three factors.
9. What are the various types of delivery system strategy?

The types of delivery system strategy for financial products include a
full-service branch, a limited-service branch, a fully automated branch,
browser-based banking and mobile phone banking.
476 Pari6: Currentissues I

10. What is the importance of communication in financial institutions and how is
a communications strategy developed?
A communications strategy is an important element of any marketing
strategy, because it affects the customer's perceptions about the products.
Developing a communications strategy involves considering aspects such as
advertising, promotion, public relations and personal selling. In financial
institutions, privacy laws are an added aspect to be considered.
communications strategy, distribution channels, retail market, p. 445

p. 444 p. 443 wholesale market, p. 445
competitor analysis, geographic cluster, p. 445
p. 444 market segmentation,
delivery system, p. 444 p. 445
demographic factors, product development,
p. 446 p. 444
Discussion
questions
1. What is the importance of the marketing of loans in the overall loans
portfolio strategy of a financial institution?
2. What is a marketing plan? Why do financial institutions need to pre-
pare one?
3. What is competitor analysis? How is it carried out?
4. The Wallis Report (1997) found that the landscape of the financial ser-
vices industry is being reshaped by the changing needs of customers.
Outline how customer needs are changing and how the financial insti-
tutions in Australia are responding to these changes.
5. What factors need to be taken into account in the development and
promotion of new financial products?
6. What are the three key determinants of the pricing strategy of a bank?
7. 'Technology is allowing innovation to occur in the financial services
industry at an accelerating pace, leading to Significant changes in finan-
cial relationships and market structures', observed the Wallis Report
(1997, p. 93). Outline the various technological innovations that have
taken place in the financial services industry and how these changes are
affecting financial relationships and market structures.
8. The advent of Internet banking offers banking firms a new frontier of
opportunities and challenges. Explain how Internet banking could be
useful in marketing lending products.
9. What systems are used by Australian financial institutions to deliver
financial services?
10. What aspects need to be considered by a bank while devising a commu-
nications strategy?
References
andfurtherreading
Bank Marketing Association 1989, Building a Financial Services Marketing Plan,
Financial Source Books, Naperville, Illinois.
Channon, D. F. 1986, Bank Strategic Management and Marketing, John Wiley & Sons,
Chichester.
Channon, D. F. 1988, Bank Strategic Management and Marketing, John Wiley & Sons,
Chichester.
Davison, H., Watkins, T. & Wright, M. 1989, 'Developing new personal financial
products - some evidence of the role of market research', International Journal of
Bank Marketing, 7(91), pp. 8-15.
Ennew, C., Watkins, T. & Wright, M. 1991, Marketing Financial Services, Butterworth
Heinemann, Oxford.
European Society for Opinion and Marketing Research 1979, Seminar on The
marketing of financial services in a competitive environment - the contribution of
marketing research', Monte Carlo, 24-26 January.
Finance Sector Union of Australia 2000, www.fsunion.org.au/docs/. accessed
15 October 2001.
Hughes, M. 1991, 'Pricing', in Marketing Financial Services, eds C. Ennew, T. Watkins
& M. Wright, Butterworth Heinemann, Oxford.
KPMG 2000, Financial Institutions Performance Survey, Sydney.
Meidan, A. 1984, Bank Marketing Management, Macmillan, London.
Miller, R. B. 1990, The Banker's Desk Book, Prentice-Hall, Englewood Cliffs, New
Jersey.
Reidenbach, R. E., Wilson, T. C., McClung, G. W. & Goeke, R. W. 1995, The Value
Driven Bank: Strategies for Total Market Satisfaction, Irwin, Burr Ridge, Illinois.
Reekie, W. D. 1972 'Marketing in banking', The Bankers' Magazine (UK), August,
pp.56-60.
Reserve Bank of Australia 2001, 'Notes on bank fees in Australia', www.rba.gov.au/.
accessed 10 December.
Stemper, R. G. 1990, The Guide to Successful Consumer Banking Strategy, John
Wiley & Sons, New York.
Wallis Report 1997, Financial System Inquiry Final Report, Australian Government
Publishing Service, Canberra.

Introduction
This chapter attempts to outline the future direction of lending. To some
extent, it is a difficult topic to tackle because directions can change dra-
matically in response to unexpected events. We can see, however, that the
nature of lending has changed over time and we can perceive trends from
the recent past. In a sense, the nature of financial intermediation has
changed and continues to change, and this affects the nature of lending.
Examining financial intermediation - the theory of how surplus funds are
transferred from those who have them (investors and lenders) to those who
require them (borrowers) - provides a good foundation for discussing
future directions.
Examining financial intermediation will show us that the market for credit
and its analysis has fundamentally changed. The following issues arise:
• the identity of lenders
• the change in the nature of regulation
• the development of new types of loan (in particular, we note that loans are
becoming more complex in nature)
• the development of new approaches to credit risk measurement
• more awareness of the risks
• the rise of new credit derivatives.
We will find in the development of credit markets that loans will become just
another instrument that can be invested in and traded. We will also note that the
development of lending products cannot be distinguished from credit risk
analysis.
Financialintermediation
As mentioned, financial intermediation is the theory of how surplus funds are
transferred from those who have them to those who need them. There are essen-
tially two ways in which funds are transferred: direct finance and indirect
finance.
Direct finance is best defined as the transfer of funds without any change of
ownership of the funds during the process. In other words, the owner of the
funds transfers those funds directly to those who require them. (This does not
mean that no facilitator is involved. We will examine this process in terms of
lending later in the chapter.) The classic example is that of a share transaction.
A broker collects offers and bids from investors and executes the transaction. At
no stage, however, does the broker own the shares when executing the trans-
action; rather, he/she receives a fee for the service.
Indirect finance is different. Funds are gathered from a large number of
sources and pooled together for lending. The relationship is different from that
of direct finance. A bank is a classic example. It collects surplus funds from a
large number of sources (the depositors). Here, the relationship is between the
bank and depositors. The bank then lends the depositors' funds to creditworthy
I 480 ParI 6: Currentissues

organisations or persons. Here, the relationship is between the bank and the
borrowers. At no stage is there a relationship between depositor and borrower;
ownership has been transformed.
The following are among the benefits of indirect finance:
• Indirect finance allows liquidity transformation - that is, the ability to have
funds at call at all times.
• It enables asset transformation - that is, the pooling of many small deposits
and the lending of larger amounts. This functionality would never be
available to small depositors.
• The pooling of deposits for lending to a variety of counterparties provides
small depositors with credit diversification.
• Finally, indirect finance automatically reduces the search fees in finding
acceptable projects in which to invest.
Indirect finance used to be the province of banks, which would collect
depositors' fund and lend this money. Ajan Thakor, a prominent banking aca-
demic, noted, 'banking used to be simple, banks took depOSits and made loans'
(Greenbaum &: Thakor 1995, p. 386). This process often led to credit rationing
because banks would only lend what they could raise from deposits. Now,
banks have more options available to raise funds.
We note two matters from the above framework. First, bank lending is
decreasing and, second, the lending process is decomposing.
Banklending
Figure 16.1 (page 482) shows that the rate of credit growth declined over the
eighteen years to 2001. Other studies, however, indicate that the rate of borrow-
ings by individuals, business and governments (mainly State governments)
continues to grow. We thus must ask the question: if banks are becoming rela-
tively less important in providing loans, which organisations are taking up the
slack?
While it is difficult to access data, there is no doubt that there has been a
growth in alternative sources for lending. One particular growth industry has
been superannuation. While superannuation funds are essentially investors in
long-term and often equity instruments, they still require some liqUidity to
ensure they have funds on hand to make pay-outs. This liqUidity is commonly
made up of short-term debt instruments issued by borrowers.
The fact that other organisations are entering debt markets is an important
development. We will later examine these institutions and sources of loans. For
now, it is important to note that the introduction of these institutions has
decreased the importance of indirect financing and, therefore, bank lending.
Many banks now participate in the direct finanCing market rather than let all
business pass.
This is the first development that we need to note. Lending is no longer
the sole province of banks; further, indirect finanCing is not as important as
it once was.
30
Year-ended growth in bank credit
..-.
20
-...
Q)
ItS
-...
..c
;:
0
C!'
10
FIGURE 16.1 Banks' credit growth
Source: Australian Prudential Regulation Authority 2001, APRA Insights, Fourth quarter,
www.apra.gov.au.
Thelendingfunction
The earlier quote from Ajan Thakor is deceptively profound: he noted that
in the past banks would carry out all banking functions. For lending, this
role included a number of different functions: sourcing the loans, funding
the loans, servicing the loans and monitoring the loans. Nowhere is the
changing face of financial institutions so dramatically indicated than with
lending.
Not that long ago, home loans, for example, were the province of banks and,
to lesser extent, bUilding societies. Banks would:
• market themselves as providers of home loan finance to attract the business
• on the application of the loan, analyse the risk to ascertain the creditworthiness
of the loan (including analysing the financial viability of the borrower and the
suitability of the security offered)
• on approval, fund the loan
• provide the facility for the borrower to make repayments
• monitor the performance of the loan and take remedial action if the borrower
fell behind on repayments.

This function has been decomposed, however, with the advent of competi-
tors. Now, with mortgage originators, one organisation can source the loan,
another can fund it, yet another can accept and process the repayments, and
investors are responsible for monitoring the loan.
Interestingly, banks that process large amounts of loans have tried to gain
support from their competitors to create mortgage-processing centres. This is a
'micro' stage between approval and funding of the loan - that is, the docu-
mentation stage. For housing loans, documentation is relatively uniform and
some banks have recognised the economies of scale that could be gained by
pooling resources. Despite some banks' efforts to create this third-party mort-
gage-processing centre, the majority of banks are fearful that the information
sharing could result in leakage of business and have resisted the proposal.
What we note here is that financial institutions earn profits from the decom-
posed functionality that is to their comparative advantage. We are now in a pos-
ition to look at the various developments in credit analysis.
Thenewlenders
We have already mentioned the change in the mix of indirect and direct
financing, with the increase in direct financing. This change has led to the rise
of a new set of lenders. History helps us understand this pattern.
Fifteen years ago, the name Aussie Home Loans was little known. Now, it is a
household name, along with such organisations as RAMS and Wizard. While
the market share for these lenders has stagnated in recent times, they shook the
established retail lenders for a time by offering home loans at substantially
lower rates. What precedence was set here?
First, these organisations (known as mortgage originators) were the first to
decompose the lending function. Second, they moved home loan finance from
the province of indirect finance into direct finance.
Banks, while attempting to move to more fee-based income, still derive the
majority of their profits from the interest spread. This spread is defined as the
difference between interest received on loans and the interest paid on deposits.
(Implicit in this arrangement is that banks carry out the whole gamut of
lending functions discussed in the previous section.)
Mortgage originators concentrate on the first of the functions: attracting
mortgage business. (Their involvement in the other functions is not important
to this discussion.) Rather than receiving an interest spread, mortgage orig-
inators receive a fee for their activities. This alerts us to the important fact that
interest revenue is not the only source of income for loans. By decomposing the
lending function, some lenders have fees as their primary source of income.
If these mortgage originators do not have the interest spread as their primary
source of income, then how are the home loans funded? This is where direct
finance becomes very important. Mortgage originators pool the mortgages that
they have originated and securitise them. (The process of securitisation is dis-
cussed in chapter 12). In other words, the mortgages are placed directly with
investors (normally through dealer panels). The investors are then responsible
for managing the risks attached to these loans.
The loan originators have alerted us to a new range of lenders: those that
operate in the direct finance market. We will deal with some of these in the
next section. One issue that is often overlooked is that much lending product
development starts in the wholesale or institutional market but is often trans-
lated to the retail market.
With loan origination, we see that loans are sourced from the retail market
but are ultimately funded in the wholesale market. Another example is fixed
rate loans, which were initially a product of the wholesale market. With the
development of the interest rate swap market, swap markets were developed for
fixed rate home loans as well.
Superannuation
andotherfunds
It is important to consider the source of funds for indirect and direct finance in
lending. While this may appear unusual, we refer back to the framework of
financial intermediation that transfers funds from surplus units to deficit units.
If banks are less important in financial intermediation, then where are savings
being sourced?
One important development in the Australian financial markets has been the
development of statutory savings through the Superannuation Guarantee Levy.
Currently, 8 per cent of an employee's salary must be placed into an approved
superannuation fund. After 2002, this will rise to 9 per cent and there are sug-
gestions that it should rise to 12-15 per cent to support Australia's ageing popu-
lation.
Regardless of the level of contributions, this levy has moved savings from
banks into superannuation funds. There is even evidence that bank accounts
are now purely transaction accounts as opposed to savings accounts. Has this
move meant greater lending opportunities? Not really. Superannuation seeks to
look after the long-term welfare of contributors, so much of its investment is in
long-term securities such as equity. It has meant, however, that banks have
moved into other areas of finance, such as managed funds, to compete with
superannuation providers.
Superannuation providers are Significant participants in the capital debt
markets for three reasons. They purchase fixed income debt securities issued by
governments, banks and corporates as part of their long-term portfolio strategy.
These securities are debt issued by these organisations; therefore, super-
annuation funds are lending to them. We should note that these securities are
classified as direct financing. Do they have all the so-called benefits of financial
intermediation?
• The secondary market provides the liquidity required to liquefy their
position if required.
• The collection of superannuation contributions for larger investments is
classic asset transformation.
• The size of superannuation funds provides diversification benefits.
I 484 Part 6: Currentissues

Search costs are kept to a mInImUm by the information provided to the
market, particularly by dealer panels. Dealer panels are appointed debt
issuers to market and place their securities; in essence, they act as brokers.
Banks are quite active participants on dealer panels, changing their role from
indirect finance (for an interest rate spread) to direct finance (for a fee).
What we observe here is classic financial intermediation, except that a
superannuation fund is carrying out the process using direct finance. The only
material difference is that the depositors (contributors) have to wait until
retirement before accessing their savings.
In this discussion, we need to question the level of skill of nonbank lenders.
Generally, the level of skill is quite low and superannuation funds tend to lend
only to credit-rated organisations. For the funds to grow the business, they will
need to access the appropriate skills.
A final note here (which we will revisit later) is that the growth of the debt
markets provides superannuation (and other) funds with diversification ben-
efits. There is a real demand for different types of debt instrument to continue
this diversification. To some extent, superannuation funds will drive further
debt development, particularly credit derivatives.
Nonbank
institutions
Nonbanks are quickly entering the lending markets. We need to dwell on the
definition of banks for a moment. Institutions in the financial markets have
been traditionally defined as banks and nonbanks. To some extent, legislation
has driven this distinction. Banks were supervised by the Reserve Bank of
Australia and the remainder were supervised by an assortment of other regula-
tory agencies, often State government based. With the advent of the Australian
Prudential Regulation Authority, this distinction is breaking down, because
this mega-regulator supervises a range of institutions. Many banks and non-
banks face the same regulations. Even the terms 'banks' and 'nonbanks' are not
descriptive, with legislation referring to authorised deposit institutions (those
institutions that accept deposits as part of their ongoing business to lend),
superannuation funds and so on.
Is there an issue now? Yes, because like the mortgage originators, a range of
different debt providers in the market do not provide any of the other features
of financial intermediation. Examples of this distinction are the store credit
cards provided by organisations such as Coles Myer and David Jones. The
funding for these products comes from earnings and, more often, debt from
banks and securitisation.
This credit funding process reiterates the trend that we have been discerning
in previous sections: lending is not the sole province of banks. These store cards
even have a nonfinancial source of funds, via earnings from profits. The result,
however, is wholesale discounting of the financial markets, because financial
intermediation provides the funds for debt products and securitisation. The
point is that nonbanks lend the funds. The other point is that they use products
that have been traditionally used (and controlled) by banks.
Insurance
companies
Insurance companies operate in terms of funds management in the same way as
managed funds, so many of the issues discussed above are relevant for these
institutions. There is an additional issue, however, with the nature of insurance
companies.
Insurance companies provide risk minimisation services. They make a pay-
ment that is contingent on an event, in return for a regular premium. When we
insure a car, for example, we pay a premium in return for reimbursement if the
car is lost or damaged. Like many of the organisations we have discussed, many
insurance companies are seeking to increase premium income and diversify
their risk.
It is here that new entrants to the credit markets and instruments cross paths.
Insurance companies are mostly reluctant to become lenders, having rarely
exposed themselves to this type of risk. They are experts in assessing risk, how-
ever, so it is likely that they will enter into credit markets via credit derivatives
to provide protection to lenders. In doing so, they gain a new source of income
as well as entering into a new area of risk.
A trend in the United States is for insurance companies to provide credit
protection against credit events via credit derivatives. The Australian
experience tends to be limited to mortgage insurance, although some
organisations are now looking to provide credit insurance to portfolios of
uninsured loans.
Like superannuation funds, insurance companies are unlikely to have
adequate credit skills to assess the credit of unrated borrowers and will need to
obtain these skills.
Thenewinstruments
We have already noted that the financial markets have evolved with a new range
of lenders for a variety of reasons. Along with these new lenders has come a
new range of lending instruments, for the following reasons:
• One financial instrument that has been traded on a regular basis by a
wide range of institutions is the Commonwealth Government bond. These
bonds are generally used to finance the Commonwealth Government
budget deficits. In other words, they are the Government's debt instrument
(known as a fixed income instrument or debt). We have observed, however,
that successive governments have brought down budget surpluses,
obviating the need for the issue of bonds. The need for fixed income debt
instruments has not changed, however, despite the Government's policy.
As part of a portfolio strategy, therefore, institutions still require fixed
income instruments for investment and liquidity purposes. This debt
instrument is now issued by institutions other than the Commonwealth
Government, such as State governments, companies and, in some cases,
overseas corporations.
[ 486 Part6: Currentissues

• Aside from the reduced issue of Commonwealth Government bonds, two
other important changes have resulted from successive Commonwealth
Government budgets.
First, privatisations have increased. To fund these privatisations,
companies are undertaking complex credit deals, as well as seeking
almost 100 per cent finance in some cases.
Second, the private sector is undertaking capital works, such as roads,
hospitals, power stations and rail links. These projects are capital
intensive and very risky. They need new-style lending instruments, credit
analysis and very complex structures.
• In chapter II, we discussed the issue of concentration risk and the need for
financial institutions to diversify their risk. For the purpose of
diversification, debt securities are being developed with different risk profiles
to satisfy the demands of fund managers. Many of these structures use
securitisation or securitisation-type structures.
• The size of the debt is ever increasing, bringing increased absolute debt size.
Credit derivatives and debt syndications are being used regularly to minimise
the credit risk.
We will now discuss some of these new instruments.
Creditderivatives
We covered credit derivatives in chapter 13. One issue that needs to be empha-
sised is that credit derivatives will continue to offer development possibilities in
credit analysis.
Throughout the chapter, we will continue to develop the issue of the trade-
ability of debt. Concentration risk poses a difficulty for managers of credit port-
folios, but there is tension in that lending officers will be reluctant, for
relationship purposes, to refuse to quote for business for long-established cus-
tomers.
To overcome the issue of concentration risk, financial institutions can use
credit derivatives to sell off the credit risk while maintaining the relationship
with the borrower. This moves us towards the possibility of completely trade-
able credit markets.
Securitisation
In earlier chapters, we discussed secuntlsation, which is a form of direct
finance. We highlighted that residential mortgages are the most popular lending
asset used for securitisation. Continued development of securitisation has been
necessary because concentration risk has emerged where the market has been
saturated by a homogenous risk. This risk is overcome via indirect finance,
where risk is diversified.
There are two points to recognise here, both looking to the diversification of
risk. One future direction of lending is that considerable energy will be directed
to creating methods and instruments for diversifying risk. Project finance, for
example, was a pioneering method of diversifying the credit risk of large pro-
jects. How does securitisation help in this area?
As mentioned earlier, residential mortgages have saturated the market and
fund managers are looking to new securitisation products. To diverSify credit
risk, many securitisation products have been created using different underlying
assets. The following list is not exhaustive:
• toll road receipts
• commercial property rentals
• credit card receivables
• artistic royalties
• lease receivables.
The underpinning principle is that the quality of the cashflows of the above
assets is of high quality. As fund managers demand more and more diversified
products, this list will expand. It is interesting to note that the banks are not
always the drivers of the development of credit products.
Secondly, securitisation has nevertheless assisted some of the smaller tra-
ditionallenders manage their portfolios. In particular, we note that some of the
smaller credit unions and building societies have geographic risk because they
operate in a small area. If the economy of that geographic area has a downturn,
which creates significant unemployment, then the credit portfolio of the
lending institution will suffer.
Given this situation, the managers have two options to avoid credit loss.
They could set up branches well outside their established geographic area. This
strategy tends to fail, given the high cost of setting up branches and the lack of
institution recognition, particularly if the institution has a region in its name. It
would be much simpler for the small institution to 'source' loans from outside
its geographic region. Securitisation allows the smaller lender to purchase loans
from another institution at a relatively low cost. (We will also discuss a new
development later in the chapter - see page 491.)
Application
ofwholesale
products
to retailcustomers
A striking feature of the development of credit markets and analysis has been
the blurring between retail and wholesale products. Most products appear to be
developed in the wholesale markets. The reason for this is Simple: given the
large value of credit products in wholesale (corporate) markets, the returns are
just as large as in the retail market.
Many of these products are now being applied in the retail markets. There are
two good examples: leasing and home loans. Leasing used to be the province of
the corporate market, but has now been sold to the retail markets. The same
trend has been experienced in the home loan equity product, which is simply a
loan on which borrowers are allowed to draw to a limit. The limit depends on
the value of the home securing the loan. Given the general appreciation of
home prices, borrowers find that they are able to use the equity in their homes
to purchase other investments such as stocks and investment properties.

The equity home loan uses two concepts. First, the unlocking of value of an
illiquid asset is the same premise that underpins securitisation. Close examin-
ation of the product, however, should reveal that it is the same product as a cor-
porate overdraft.
The blurring of corporate and retail products is expected to continue to
develop, probably in hand with the development of private banking that looks
after the interests of wealthy individuals. These types of customers will demand
more sophisticated products.
Complex
structures
As the economy develops, loans become incrementally larger. The risks also
multiply. We have already mentioned the introduction of loans that are predi-
cated on toll road receipts, for example. The ability to repay these loans would
be based on the number of vehicles that pay the toll. Particularly for earlier
loans, it was difficult to assess the number of vehicles that use a toll road and
thus the risk. It still is an inexact science. This is evidence that loans are
becoming more complex.
Given the types of loan that are being sought, lenders are increasingly asked
to look at more and more complex structures. Wrapped up in the credit risk are
issues that will affect the ability of a borrower to repay, such as:
• the credit risk of suppliers and buyers
• political risk, which ranges from competition policy to issues of native title
• environmental risk, including the risk to earnings of borrowers that emit
greenhouse gases.
Complex risks will make lenders wary. While many areas of credit are liber-
alising, this area is a concern; for example, the New South Wales Government
had to deal with the default of the airport-railway link. How the documen-
tation was drafted would have had a significant bearing on the outcome of this
issue.
Creditmarkets
It seems unusual to state that the credit markets appear to be the most under-
developed. Of all the risks taken by financial institutions, credit was the first to
be recognised. Lending and credit risk has been around for a long time, but this
market seems to be the last to be developed.
Great strides have been made in detecting, measuring and managing other
financial risks. Interest rate risk is a good example. Much thought and tech-
nology have been applied to this topic. Much funding has been provided for the
development of risk analysis systems. New products have been developed, such
as bank accepted bills, bond futures, interest rate swaps and interest rate
options. Yet few financial institutions have failed as a result of interest rate risk.
We now have fully developed interest rate risk markets where interest rates are
actively traded.
I' -
Credit risk is the major reason that financial institutions fail. Will we see the
development of actively traded credit markets? Credit is already traded; bank
accepted bills, certificates of deposits and commercial paper are all examples of
debt or credit that has been actively traded. These instruments, however, are
short term and simple in nature.
The question is whether there will be an actively traded credit market that
takes in more complicated debt products. The development of credit derivative
tools and other developments over the past fifteen years have shown that this
type of market is most likely.
Securitisation
We have already discussed securitisation. It is sufficient to say that the pooling
of small loans into financial instruments is good evidence that credit will be
traded.
Transferable
loancertificates
Transferable loan certificates were the first instruments that were truly loans
that could be traded on the financial markets. They came into prominence in
the mid-1980s, with the first Australian bank to arrange an issue being BT
Australia. The certificates were long-term loans that had full documentation,
unlike the promise to pay (like commercial paper), yet had the ability to be
on-traded on the financial markets.
These securities had their origin in the third world debt markets, where
banks desired a mechanism to remove third world debt from their statements of
financial position. Transferable loan certificates were loans negotiated between
borrower and lender. The documentation, however, provided the lender with
the ability to create certificates of loan that can be sold. The certificates carried
the original terms and conditions of the loan.
In reality, while this market was groundbreaking, it did not have any depth,
with many of the transferable loan certificates remaining on the statement of finan-
cial position of the original lenders. In addition, the certificates were funded by
the deposit base of the lender and therefore displayed all the classic conditions of
financial intermediation. They showed, nevertheless, that loans could be traded.
Loansales
If it is true that the Australian markets follow the overseas trends, then we will
find that the US market phenomenon of trade in domestic loans will become a
reality in Australia. The US market has a well-developed and deep secondary
market for credit. The loans that are traded are traditional short-term loans and
highly leveraged transactions (loans that are similar to those used in leveraged
buy-outs).
This trend of following overseas developments has many precedents. We note
them in the equity markets (new instruments), debt markets (for example,
securitisation and credit derivatives) and risk management products (particu-
larly with the development of new products).

As long as the above loans have a number of characteristics, they can be
traded in the secondary loan markets in the United States. Characteristic tra-
ditional short-term loans:
• are secured by the assets of the borrowing firm
• are made to investment-grade borrowers or better
• are short term (ninety days or less)
• have yields closely tied to the commercial paper rate
• are sold in units worth $1 million and higher. (Saunders 2000)
Characteristic highly leveraged loans:
• are secured by the assets of the borrowing firm (usually senior secured)
• are long term (often with three- to six-year maturities)
• have floating rates tied to the London Inter Bank Offer Rate (LIBOR), the
prime rate or commercial deposit (CD) rate (normally 200-275 basis points
above these rates)
• have strong covenant protection. (Saunders 2000)
This tells us that the credit markets in Australia have a precedence to follow.
There is a distinct possibility that we will observe a deep secondary domestic
market for company debt. If we analyse the above characteristics, we note that
we need loans that are destined to be traded based on common interest rates.
Credit portfolio swaps are a recent (and not well-publicised) development in
loan sales. We mentioned earlier that many small lenders find it difficult to geo-
graphically diverSify their portfolio. Investment banks have found, however,
that they can arrange the swap of one portfolio for another portfolio of equal
value at another geographically different small lender. Given the number of
small lenders in Australia, this market has great scope to expand.
Globalisation
No discussion of the future of lending can ignore the effects of globalisation.
The credit markets are becoming less segmented and borrowers move easily
from one credit market to the next. Such developments allow borrowers to take
advantage of both the price and other benefits such as taxation relief. What
does the globalisation of the credit markets bring?
First, it provides easy knowledge transfer. In the past, the development of
financial markets through knowledge transfer would require the movement of
personnel and technology. The bottom line was that it was costly and usually
meant a time lag. With improved technology, such delays are almost non-
existent. Transactions can be made at any location as long as the execution of
deals can be assured.
Second, the globalisation of markets provides deeper markets for various
instruments. This is important when concentration risk is increasing, given the
size of the domestic market. We have seen evidence of this in the securitisation
market. With the concentration of residential mortgages in the securitisation
market, a number of issues have been successfully executed in the euro markets.
The globalisation of markets is expected to continue.
Regulation
The nature of financial regulation has altered in the past twenty years. This has
changed the way in which lenders have carried out their lending business and,
in some cases, has distorted the lending decision.
Australia's financial regulation, including that of lending, is prudential. In
practical terms, this means that senior management of financial institutions
make decisions within the framework of guidelines of the Australian Prudential
Regulation Authority. In chapters 12 and 13, we looked at a number of these
issues.
The previous regime was prescriptive, to the extent that the Reserve Bank of
Australia (the regulator before the Australian Prudential Regulation Authority)
would direct banks to lend to certain sectors of the economy. This interfered
with the efficient operation of financial intermediation whereby we expect sur-
plus funds to be directed to the appropriate deficit unit.
Prudential regulation allows for better management of resources, but this
does not mean that it is perfect, as shown when capital adequacy was intro-
duced. With the homogenisation of corporate risk and the 50 per cent risk
weighting of residential mortgages, banks in particular chased the residential
market because it was more capital efficient. With the promulgation of the new
guidelines for capital adequacy, some of these distortions will be lessened.
There is a push from some parties in Australia for the re-regulation of the
financial system. It is not clear whether such a change would influence the
lending business of approved deposit institutions. It is clear, however, that any
changes in the future will have an effect on lending. Two areas seem to be
always affected:
1. the types of loan provided. Our example showed that capital adequacy favours
home loans.
2. the pricing of loans. Regulation always brings costs. Re-regulation would
probably add to the cost of lending. If regulation involves changes to the
capital adequacy guidelines, then there will always be some change to
pricing. If the capital requirement increased, then we would expect the cost
of loans to rise; a decrease in the requirement would be expected to reduce
the cost of borrowing.
Prudential lending in its present form will continue to allow approved
deposit institutions to innovate in markets such as credit.
The advent of the Australian Prudential Regulation Authority has meant that
all authorised deposit institutions are supervised using the same regulations.
While this may seem desirable, it is a burden on smaller institutions such as
credit unions that do not possess the sophistication of the major banks, particu-
larly in terms of risk management and reporting. The regulatory set-up
undoubtedly imposes a cost on their lending processes.
At the time of writing, there has been conjecture about the BIB collapse in
terms of prudential regulation, given that the company was supervised by the
Australian Prudential Regulation Authority. Any consequence for regulation

will not be known until the release of the Royal Commission report. Given the
criticism of the Australian Prudential Regulation Authority, however, there will
probably be greater scrutiny of all authority-regulated organisations, including
the credit portfolios of lending institutions.
The focus of this section has been on organisations that come under the regu-
lator. But what of those organisations that fall outside the authority's ambit?
The retailers mentioned earlier are an example. What protections are built into
the system to protect stakeholders if these pseudo-lenders fail? Would lending
failure affect individuals or the whole economy? Like most questions of this
nature, we may not know until the event occurs (if it does in our lifetime).
Theeffectsofelectronic
banking
While it may seem that electronic banking has nothing to do with financial
intermediation, this is not true. The essential essence of financial intermedi-
ation is to bring surplus and deficit units together. Lending through electronic
banking does this with frightening speed.
It has already had an impact in the area of lending in two areas. First, it is
now commonplace to apply for credit cards over the Internet. Second, with the
advent of Internet services, customers can apply for loans on financial insti-
tution websites and then seek the best loan package.
Lending will become more electronic. The efficiency benefits are too hard to
ignore, particularly given that electronic applications can be processed through
mathematical models. There are risks as well, however.
The major risk is that of lack of identity. While documentation with many of
these services, particularly credit cards, has reduced, it has also opened a new
exposure for banks. Is the card applicant who he/she purports to be? Can the
applicant financially support the loan?
Many senior bankers state that it is important to interview potential bor-
rowers because information that may not be captured on a form will be ascer-
tained in a conversation. This means that electronic lending needs to be
sophisticated enough to gather all vital information.
Summary
1. How does the development of financial intermediation affect lending and
credit markets?
Financial intermediation is the focus of lending. It is the process of how sur-
plus funds are collected and then dispersed through the financial markets,
from surplus units to deficit units. For many decades, primarily banks
carried out this function.
2. Why does the lending rate grow despite the fall in bank lending?
In the past fifteen years, bank lending growth fell despite increased bor-
rowing by individuals and business. This is explained by the growth of a new
style of lender.
3. What is the decomposition of the lending function?
The new style of lender can be explained by the decomposition of the
lending function. Banks traditionally carried out all the functions of bank
lending: marketing, processing for approval or decline, providing the facility
for the loan to be repaid and monitoring the loan's performance. Today, mort-
gage originators compete with banks in the first and second functions.
4. Why are new lenders entering the market?
The decomposition of the lending function has meant that a number of
organisations can now concentrate on one area of lending where they have
the comparative advantage and can be profitable. The prime example is the
mortgage originator, which markets and processes the loan, but does not
fund or monitor it.
5. How are superannuation funds and other funds operating as lenders?
The decline in direct finance from banks has led some new lenders to enter
the market. The Superannuation Guarantee Levy has resulted in super-
annuation funds becoming Significant lenders, particularly with the decline
of the government bond market.
6. Why are nonbanks important to the market?
The decline of direct finance has meant that other institutions have entered
the lending market. Businesses with a good source of cash, whether earnings
or unused credit lines, have now become lenders. Retailers, via store credit
cards, are an example.
7. What are the possibilities for insurance companies as participants of the credit
markets?
Insurance companies traditionally are reluctant lenders, despite insurance
being one element of lending. They provide risk-minimisation services, how-
ever, and are likely to provide the impetus for the growth of the credit deriv-
ative market.
8. What are the drivers of new lending products?
The financial markets are now witnessing a plethora of new instruments, for
two reasons. First, buyers of debt are looking for new instruments to take the
place of the everdiminishing pool of government bonds, with the desire to
diversify their portfolio. Second, concentration risk is now recognised and
new instruments, with exposure to new markets, allow for this risk to be
minimised.
9. What is the future of credit derivatives?
As well as providing the mechanism for reducing credit risk, credit derivatives
point us to the future where credit markets will become fully tradeable.
10. What is the future of securitisation?
In discussing diversification, securitisation provides the ideal opportunity to
create exposures to alternative markets. This occurs via the securitisation of
cashflows of different types of asset.
494 !liar!
6: Currentissues I
11. How are wholesale products applied to retail customers?
As the credit markets develop, products that are developed for the wholesale
market are being used in the retail market.
12. How have developments in lending products changed their complexity?
Product developments have made lending more complicated. Some risks
have not traditionally been recognised or processed by lenders, but lenders
will be increasingly exposed to more and diverse risks.
13. What are the new credit markets?
The drive for new products and the introduction of new lenders are moving
us towards the development of fully traded credit markets, which are already
observed in the United States.
14. What are transferable loan certificates and loan sales?
With the desire for new traded credit markets, transferable loan certificates
and loan sales were developed. We expect the loan sale market to develop in
Australia within the medium term.
15. What are the effects of globalisation?
Globalisation has had two effects. First, knowledge about credit risk can be
easily transferred. Second, the national borders for credit markets are now
disintegrating, as they are for other markets such as foreign exchange. This
should result in deep homogenous markets for credit risk.
16. What are the effects of changing regulation?
The current prudential regulation in Australia has many effects. Some
lenders have the opportunity to innovate, while for others, regulatory
imperatives may be a burden and anti-competitive. Any tightening in regu-
lations, however, will come at a cost to financial institutions and thus add to
the cost of lending.
17. What effect will electronic banking have on lending?
Electronic banking places some space between the borrower and the lender.
This face-free style of lending risks missing vital information if electronic
applications do not gather that information. On the positive side, electronic
lending makes processing more efficient.
dealer panels, p. 484 financial intermediation, interest spread, p. 483

direct finance, p. 480 p. 480
fee-based income, p. 483 indirect finance, p. 480
Discussion
questions
1. Why is financial intermediation important to the discussion of the
development of credit markets?
2. Name the major drivers of the development of new instruments in the
credit markets.
3. Which organisations are pushing the development and use of new
credit products? Why?
4. Compare and contrast credit and interest rate risk markets.
5. What would be the effect of successive Commonwealth Government
deficits on debt markets?
6. Why would a bank sell a loan?
7. Which specific developments assist small borrowers? What are their
particular risks?
8. In your assessment, what factors are hampering tradeable debt in
Australia?
9. Discuss the advantages and disadvantages of having global credit
markets.
10. Why is regulation not cost neutral for credit markets?
References
andfurtherreading
Saunders, A. 2000, Financial Institutions Management, McGraw-Hili Higher
Education, New York.
Greenbaum, S. J. & Thakor, A. V. 1995, Contemporary Financial Intermediation, The
Dryden United States of America Press, Orlando, Florida.

Casestudy1 - BoatBuildersPtyLtd*
learningobjectives
After completing this case study, you should be able to:
1. critically examine a set of financial statements for a borrower, from the per-
spective of how well those financial statements represent the real position of
the business
2. develop a set of questions about the financial statements to ask the owner(s)/
accountant of the business before undertaking a detailed financial analysis
3. modify the financial statements on the basis of the answers that you find to
your questions.
Introduction
The detailed analysis of financial statements is an important task for any lender.
Chapter 2 deals with how ratios are calculated and analysed, how projections
are sensitised and how risks are identified. Another important step is required,
however, before this detailed financial analysis. It involves a critical examin-
ation of the financial statements of the borrower. The purpose of this step is to
ensure the financial statements accurately reflect the real state of the business.
If they do not, then the detailed financial analysis is likely to end up being a
case of 'garbage in, garbage out' (GIGO).
Consider the following illustrations of GIGO in financial analysis:
• calculation and analysis of liquidity (via a current ratio) when a proportion
of the debtors shown on the balance sheet are bad debts
• calculation and analysis of a gross margin using a level of sales for the
business that has been deliberately understated
• calculation and analysis of the gearing of a business when the capital level
has been inflated by an artificially high land valuation on the balance sheet.
How does the lender eliminate the possibility of GIGO? It is not easy to set
strict rules to follow, but the following are some ideas:
• Maintain a critical mindset when conSidering the financials.
• Continually ask whether the financial statements accurately reflect what you
know about the business.
• Get to know the business by asking questions of the proprietor or
accountant, by making site visits and by researching the characteristics of
similar businesses in that industry.
Chapter 9 elaborates on these ideas in the context of lending to small
business. In chapter 9, the point is made that coming up with the right ques-
tions is a skill that lenders develop with experience. The best lenders have
* Disclaimer: This case study is hypothetical. Any resemblance to actual events, locales, entities or persons is
entirely coincidental.
Casestudy1: BoatBuildersPly Ltd 499

an impressive ability to read a set of financials and quickly identify the key
questions to ask the owner/accountant. They also tend to make insightful
observations during a site visit.
For the following case study on Boat Builders Pty Ltd, a site visit and a dia-
logue with the owner/accountant is obviously not possible. For this reason, you
are required only to develop a set of questions to ask the owner/accountant
about the financials. Make sure that you read and analyse the information con-
tained in the case study thoroughly, because your understanding of this infor-
mation will determine the quality of the questions that you are able to develop.
BoatBuildersPtyLtd
Date: 1 September 2003
Background
Boat Builders Pty Ltd has been a customer of Excel Bank since 1991. It is based
in Sunshine, which is a regional centre and the port for a thriving fishing industry.
The business has developed into the largest aluminium boat building business
in Sunshine and one of the larger aluminium boat builders in the State.
Reg and Judith Gibb own Boat Builders. The structure is a standard
two-dollar company, with the Gibbs owning one share each. Reg is a qualified
boat builder and Judith is experienced in office management. Both are aged in
their late 40s.
They started the company in 1991. Trading conditions were extremely diffi-
cult during the first two years due to high interest rates and depressed econ-
omic conditions, but the company has since become well established. Reg is
well respected in the industry as a boat builder.
Reg and Judith have three children: Jack, Ruby and Charles. Jack is 30 years
old and has worked in the business since leaving school. Ruby and Charles are
both studying at university and have no plans to work in the business.
Boat Builders recently completed building two 20-metre boats for Deep Sea
Fishing Enterprises Ltd (DSFE), which is headquartered in Sunshine but also has
fishing operations elsewhere in Australia. DSFE has plans to expand its operations
over the next three years and has indicated to Boat Builders that it will be lodging
further orders for fishing vessels over the next three years. Over the past year,
DSFE has accounted for 65 per cent of the turnover of Boat Builders.
Boat Builders currently leases premises in the port area. These premises have
proven unsatisfactory because they are quite small, given the size and number
of boats that have been built over the past year. Space limitations prevented
Boat Builders from participating in tenders to build two large boats during the
previous financial year.
The ongoing demand for boats from customers, particularly from DSFE,
led Boat Builders to decide during 2002 to build a large factory unit on land
that it purchased two years ago for $94000. Construction of the factory unit
commenced in January 2003 and is now close to completion. Boat Builders is
I 500 ParI7: Casestudies I

scheduled to move into the factory unit in November 2003. This coordinates
well with the expiry of the lease on the existing factory unit at the end of
October 2003.
So far, construction expenses have totalled $230000. A bill facility has been
used to finance these expenses, with a top-up coming from the owners of Boat
Builders. The builder of the factory unit recently provided a detailed conser-
vative estimate of the remaining costs: $220000 over October and November.
Once completed, the factory unit and associated land will have an estimated
value of $650000.
The existing borrowings for Boat Builders are as follows.
Current
Purpose Limit balance
Overdraft Working capital $110000 -$82000

Fixed term loan no. 1 Factory equipment n/a -$21841
Fixed term loan no. 2 Land n/a -$58778
Bill facility Construction costs $220000 -$220000
nJa Not applicable
Recent account balance information for the overdraft is as follows.
lowestbalance Highestbalance Monthlycredit Averagemonthly

1 2
forthemonth forthemonth turnover balance
July 02 -18142 46061 190520 41395

August 02 -22578 33843 121240 28085
September 02 -24183 83221 242480 27921
October 02 -27581 29277 144276 18092
November 02 -30207 -4936 69280 -5092
December 02 --43155 51687 121240 46895
January 03 -19990 27146 103920 22170
February 03 -20402 -9671 144276 -14062
March 03 -78648 --4575 69280 -8145
April 03 -80575 -12194 185231 -66423
May 03 -89058 -16166 156519 -50494
June 03 -102050 12000 144276 -88322

Current balance 4000
Annual credit turnover 1 692538
Notes
l. The total value of deposits into tbe cheque account in a month. Normally, this would tally with the
monthly sales of the business.
2. The average of each of the daily closing balances for the month.
I Casestudy1: BoatBuildersPty ltd 501

Requestforincreased
funding
Reg and Judith Gibb have approached you with a request for the following
increases in the facilities for Boat Builders.
Current Proposed
Facility balance/limit balance/limit Comment
Overdraft $110000 $300000 Increase in base limit (see

discussion below)
Bill facility 5220000 5220000 Bill facility matures in October

2003. Facility is to be
refinanced on an interest-only
basis for three years.
Lease for boat lifter nla $60000 To be purchased in October

2003
Lease for metal nla $140000 To be installed in the new

fabrication factory (October 2003)
machinery
n/a Not applicable
According to the directors of Boat Builders, the increase in the overdraft limit
to $300000 will be required only until June 2004. At that point, the limit will
be reduced to $11 0000. The increase in the overdraft limit is to cover the
following cash outflows: a taxation payment of $95000 due on October 2003;
construction costs of $220000 which will be payable during October and
November 2003; superannuation payments due in December 2003; and the cost
of increasing stock levels following their reduction before the move to the new
factory.
Since May 2003, DSFE has owed $280000 to Boat Builders. This debt relates
to a boat that was built for use in a joint venture between DSFE and the Com-
monwealth Scientific and Industrial Research Organisation (CSIRO). Reg Gibb
believes that Boat Builders will receive this money by January 2004. This would
allow the increase in the overdraft limit to be removed, returning the overdraft
to its previous level of $11 0000.
The Gibbs have offered the following security for the borrowing:
1. a first mortgage over the soon-to-be-completed factory unit (valued at
$650000)
2. unlimited guarantees by the directors, Reg and Judith Gibb
3. a fixed and floating charge over the assets of Boat Builders
4. a registered first mortgage over the residence of Reg and Judith Gibb (valued
at $260000).
Financialstatements
The following financial statements for Boat Builders (pages 503-5) were prepared
by Accounting Partners.
I 502 Part7: Casestudies I

Accounting Partners
Certified Practising Accountants
15 Marine Parade
Sunshine
Boat Builders Pty Ltd

Disclaimer
For the year ended 30 June 2003
We have prepared the accompanying statement of financial position as at 30 June

2003 and statement of financial performance for the year then ended ('the Accounts')
from the books and records of the Company and other information provided by the
officers of that Company and at the request of and exclusively for the use and benefit
of the Company.
Under the terms of our engagement we have not audited the accounting records of
the Company or the Accounts. Accordingly, we express no opinion on whether they
present a true and fair view of the position or of the year's trading and no warranty of
accuracy or reliability is given.
In accordance with our firm policy we advise that neither the firm nor any member
or employee of the firm undertakes responsibility arising in any way whatsoever to
any person (other than the owners) in respect of the Accounts including any errors or
omissions therein arising through negligence or otherwise however caused.
Accounting Partners
Certified Practising Accountants
15 July 2003
BoatBuildersPtyLId
Current
year Trading
statement
fortheyearended30June2003 last year
$1692538 SALES 5418829
LESS COSTS OF SALES

67734 Consumables (welding) 17481
37261 Drafting services
257229 Direct wages 123424

2502 Elect rici ty 2188
2670 Freight 10646

'53828 Painting and sand blasting 40275
637 Repairs - plant and equipment
2176 Replacement tools 509

879402 Aluminium purchases 54877
101861 Subcontractors 8114
1405299 TOTAL COST OF SALES 257514
287239 GROSS PROFIT FROM TRADING 161314
These accounts have not been audited and constitute special-purpose financial statements. This statement must be read in
conjunction with the allached disclaimer of Accounling Partners.
I Casestudy1: BoalBuildersPly Ltd 503 I

BoalBuildersPlyLtd
Current
year Statement
ollinancialposilionasat30June2003 Lastyear
CURRENT ASSETS
$ 35168 Debtors $ 35530
30000 Stock 30000
4978 Cash 600
1545 Director's loan a Gibb) 1545
36026 Director's loan (R Gibb) 66410
107717 TOTAL CURRENT ASSETS 134085
NONCURRENT ASSETS
103000 Factory unit land 103000
140803 Plant and eqUipment - at cost 40450
(44469) Less Provision for depreciation (23062)
96334 Written-down value 17388
66756 Motor vehicles - at cost 31147
(1960l) Less Provision for depreciation (17098)
4353 Office eqUipment - at cost 2964
(1 572) Less Provision for depreciation (l 127)
480 Capitalised borrowing costs 480
(288) Less Provision for amortisation (191)
191 Amortised value 287
249461 TOTAL NONCURRENT ASSETS 136560
357178 TOTAL ASSETS 270645
CURRENT LIABILITIES
(4000) Overdraft 66875
7001 Creditors 35156
216780 Bank bill
219781 TOTAL CURRENT LIABILITIES 102031
NONCURRENT LIABILITIES
40916 Loan - R &] Gibb 43672
Loan - Boat Builders Ply Ltd superannuation fund 19931
Loan-Bank 13832
22496 Fixed term loan 1 - factory equipment 7869
60048 Fixed tenn loan 2 - land 83205
123460 TOTAL NONCURRENT LIABILITIES 168509
343241 TOTAL LIABILITIES 270540
SHAREHOLDERS' FUNDS
2 Paid-up capital 2
13935 Retained earnings 103
13937 TOTAL SHAREHOLDERS' FUNDS 105
357178 TOTAL LIABILITIES AND SHAREHOLDERS' FUNDS 270645
These accounts have not been audited and constitute special-purpose financial statements, This statement must be read in
conjunction with the attached disclaimer of Accounting Partners.
I 504 Pari7: Casestudies I

BoatBuildersPtyLid
Current
year Statement
offinancialperformancefortheyearended3DJune2003 Lastyear
EXPENDITURE
$ 6298 Accounting $ 4723
1438 Advertising 719
3677 Bank charges 1067
96 Borrowing costs 96
Conference fees 345
21408 Depreciation on plant and equipment 41+0
5432 Depreciation on motor vehicles 5002
444 Depreciation on office equipment 414
2060 Donations 157
179 Fines
335 Hire of plant and equipment 3556
General insurance 4001
9340 Work Care insurance
11198 Bank interest 28186
3289 Interest - Boat Builders Pty Ltd superannuation fund 3289
838 Interest fixed term loan 2 (land)
12224 Leasing payments 11500
1018 Legal costs
1134 Loss on sale of fixed assets
11lO3 Petrol and oil 9031
7358 Repairs and maintenance 1646
2923 Registration and insurance 1415
(7181) Less Employee contribution
57 Permits, licences and fees 5R3
1605 Postage
R87 Printing and stationery 293
79 Protective clothing and safety gear 10R5
3706 Rates and taxes 3032
11021 Rent 9899
53 Repairs and maintenance 845
1043 Staff training 21
35922 Superannuation contributions 202
5025 Telephone 4941
1937 Travelling expenses 1468
828 Union fees
156775 TOTAL EXPENDITURE 93670
130464 NET PROFIT 67644
OTHER INCOME
13832 Capital gain on sale of fixed assets 35681
369 Net property income
14201 TOTAL OTHER INCOME 35681
144665 OPERATING PROFIT (BEFORE TAX) 103325
These accounts have not been audited and constitute special-purpose financial statements. This statement must be read in
conjunction with the attached disclaimer of Accounting Partners.
Casestudy1. BoalBuildersPly Ltd 505 I

Discussion
questions
In the following discussion questions, you are not being asked to conduct
detailed financial analysis of the statement of financial position and the state-
ment of financial performance. This financial analysis, which includes ratio
analysis of the the statement of financial position and the statement of financial
performance, will be done in case study 2. In this case study, you only need to
consider the financial statements in terms of how accurately you feel they
depict the true state of the business.
1. The accountant has stated in the footnote to these financial statements that
the accounts 'constitute special-purpose financial statements'.
(a) What are special-purpose financial statements and how are they different
from general-purpose financial statements?
(b) What is the significance to you, as a lender, of these being special-purpose
financial statements?
(Most introductory accounting textbooks contain information on both
special-purpose and general-purpose financial statements. Chapter 9 also dis-
cusses these two types of statement.)
2. Identify any concerns that you have about the financial statements supplied
for Boat Builders in terms of them not accurately depicting the true position
of the business (for reasons of error, accounting assumptions, creativity or
dishonesty) .
3. Rank all of your concerns in terms of their significance to you as a lender to
this business. Justify your rankings.
4. Based on your concerns, identify five key questions that you would ask the
proprietors of the business about their financial statements.
5. In a practical lending situation, the proprietors/accountant would answer the
questions that you have identified. Potentially, this could lead to the finan-
cial statements being modified before your detailed financial analysis com-
mences. In the context of this case study, there is no proprietor or
accountant to provide answers to your questions, so you are asked to modify
the financial statements based on your best guess of what the answers to
your five key questions would be. Explain and justify each modification that
you would make.

Casestudy2 - FinancialanalysisofBoat
BuildersPtyltd*
learningobjectives
1. complete a detailed financial ratio analysis of a series of statements of financial
position and a statement of financial performance
2. complete a detailed financial analysis of a cashflow budget using a five-stage
checklist
3. generate conclusions from this analysis about the risks you face as a lender to
this business.
Introduction
You need to complete case study 1 (Boat Builders Pty Ltd) before commencing
this case study. The focus in case study 1 was on identifying any concerns that
you had about the balance sheets and profit and loss statements for Boat
Builders, to ensure there was limited scope for garbage-in, garbage-out (GIGO)
in the financial analysis stage. In this second case study, the focus is on the sub-
sequent financial analysis stage.
Based on the concerns that you identified in case study 1, you were asked to
make adjustments to the financial statements. These are the adjusted financial
statements that you will analyse in this second case study.
BoatBuildersPtyltd
Date: 1 July 2003
Background
Case study 1 provided a detailed background on Boat Builders. Here, you are
asked to conduct a detailed financial ratio analysis of the balance sheets and the
profit and loss statements that the directors of Boat Builders have supplied.
Many different financial ratios could be used as part of this analysis, but we
recommend that you use the following ratios (and ratio groups).
Short-term
liquidityratios
Current ratio Current assets divided by current liabilities
Quick ratio (Current assets - stock) divided by (current liabilities - overdraft)
Debtors turnover Trade debtors divided by average daily sales (continued)
* Disclaimer: This case study is hypothetical. Any resemblance to actual events. locales, entities or persons is
I Casestudy2 Financialanalysisof BoatBuildersPly Ltd 507 I

Short-term
liquidity
ratioscontinued
Stock turnover Average stock divided by daily cost of goods sold
Creditors turnover Trade creditors divided by average daily purchases
Longer
termsolvency
ratios
Shareholders' funds divided by total assets
Shareholders' funds divided by outside liabilities
Fixed assets divided by shareholders' funds
Business
performance
ratios
Gross margin (Sales - cost of goods sold) divided by sales
Net margin Net profit divided by sales
Operating expenses divided by sales
A potential trap with ratio analysis is that it can end up being superficial if it
focuses on the ratio values without going into what lies behind those values.
Here are some ways in which to make your ratio analysis more in depth.
1. Refertothesourcedata
Relate your analysis of each ratio back to the underlying figures in the balance
sheet or profit and loss statement used in the calculation of the ratio. Consider
a longer term solvency ratio: shareholders' funds divided by total assets, for
example, which has changed from 47 per cent to 40 per cent to 37 per cent over
a three-year period. Why has this change in the ratio value occurred? Has it been
due to a growth in total assets while shareholders' funds remain constant? Or,
to some other combination of change in total assets and shareholders' funds?
2. Relatecomments tothetypeofbusiness concerned
Ratio analysis should be used to say something about the business concerned.
If the business is a boat builder, then the comments about stock turnover
should relate to the stock typically held by a boat building business. As an
example, what proportion of work-in-progress is contained in Boat Builders'
stock figure?
3. Makesomeconclusions aboutrisks
Lenders are ultimately interested about risks, so ratio analysis should be used to
make conclusions about the risks that the lender to this business faces. If the
liquidity position of the business is poor, then what are risks to the lender?
Request
forincreased
funding
The directors of Boat Builders have requested the following increase in bank
funding.
I 508 Part7 Casestudies

Current Proposed
Facility balance/limit balance/limit Comment
Overdraft $110000 $300000 Increase in base limit (see discussion

below)
Bill facility $220000 $220000 Bill facility matures in October 2003.

Facility is to be refinanced on an
interest-only hasis for three years.
Lease for boat lifter nla $60000 To be purchased in October 2003
Lease for metal nla $140000 To be installed in the new factory

fabrication machinery (October 2003)
n/a Not applicable
The directors have provided a cash flow budget, with the following notes, to
support their request for an increase in the overdraft limit in particular:
1. The $300000 overdraft limit will be required only until June 2004. At that
point, the limit will be returned back to $110 000.
2. The increase in the overdraft limit is to cover:
a taxation payment of $95000 due in October 2003
construction costs of $220000 which will be payable during October and
November 2003
superannuation payments due in December 2003
the purchase of additional stock following a reduction in stock before the
move to the new factory.
3. Since May 2003, Deep Sea Fishing Enterprises Ltd (DSFE) has owed
$280000 to Boat Builders. This debt relates to a boat that was built for use in
a joint venture between DSFE and the Commonwealth Scientific and Indus-
trial Research Organisation (CSIRO). DSFE is waiting for payment from its
government partner. According to documents provided by DSFE, this pay-
ment will be made in four tranches as follows: October ($100000),
November ($100000), December ($40000) and January ($40000).
4. The figure of $1 615000 for 'Sales' is made up of contracts with both DSFE
(65 per cent) and other customers (35 per cent). Boat Builders expects that
these sales will be paid within thirty days.
You are asked to analyse the cashflow using the five-stage cashflow checklist
outlined in table 9.7 (page 300). In particular, you are asked to concentrate on
parts 4 and 5 of the checklist: analysing the validity of the underlying assump-
tions and critically considering the issue of sensitivity analysis.
I Casestudy2: Financialanalysisof BaalBuildersPly Ltd 509 I

0
"'C
<»
::l
:-:'
C)
'"
if>
CD
if>
Opening overdraft balance 10000 -126870 -120416 -240175 -226845 -280191 -299155 -294510 -259014 -95885 -54839 -107907 -1 545957
CASH INFLOWS
DSFE Ltd Payments 100000 100000 40000 40000 280000
Sales 40000 110 000 130000 120000 165000 190000 220000 235000 110 000 105000 190000 1615000
TOTAL CASH INFLOWS 100000 140000 150000 170000 120000 165000 190000 220000 235000 110 000 105000 190000 1895000
COST OF SALES
Consumables (welding) 1545 1545 4918 7869 8656 9050 9050 9443 2361 2754 7869 9443 74 503
Drafting services 2820 4511 4963 '5188 5188 5414 1 353 1579 4511 5414 40941
Direct wages 13 596 13 596 20600 20600 20600 20600 20600 20600 20600 20600 20600 20600 233 192
Electricity 103 103 180 288 317 332 332 346 87 101 288 346 2823
Freight 194 309 340 355 355 371 93 108 309 371 2805
Repairs - plant 39 62 68 71 71 74 19 22 62 74 561
Tools 155 247 272 284 284 297 74 87 247 297 2243
Material purchases
(mainly aluminium) 2060 2060 169950 ]06605 117420 123 600 123 600 127720 31930 36050 106090 127 720 1074805
Subcontractors 7725 12360 13 390 14420 14420 14420 4120 4120 12360 14420 111 755
CASH EXPENSES
Accountant fees 5923 7571 13 493
Advertising 133 133 l33 133 133 133 133 133 133 133 133 133 1594
Bank charges 22 33 275 440 484 506 506 528 132 155 440 528 4048
Hire of equipment 412 412 412 412 412 412 412 412 412 412 412 412 4944
Interest - overdraft 6180 6180 6180 6180 24720
Inlerest - term loan '511 511 511 511 511 511 511 511 511 511 511 511 6131
Motor vehicle expenses 1988 1988 1988 J 988 1988 1988 1988 1988 ] 988 1988 1988 1988 23855
Licences 206 206
Postage 149 149 149 149 149 149 149 149 149 149 149 J49 1792
Printing 248 248 248 248 993
Protective clothing 258 258 258 258 1030
Rates and taxes 4120 4120
Rent 918 918 918 2753
Staff training 1545 1 545 3090
Superannuation 51500 5] 500
Telephone 1407 1407 1407 1407 5628
Travel expenses 185 185 185 185 185 185 185 185 185 185 185 185 2225
Union fees 927 927
OTHER CASH OUTFLOWS
Taxation 95000 95000
Construction costs 110000 110000 220000
TOTAL CASH OUTFLOWS 236870 133546 269759 156670 173346 183964 J85 355 J84504 71 871 68953 158068 188771 2011678
Closing overdraft balance -126870 -120416 -240l75 -226845 -280191 -2991'55 -294510 -259014 -95885 -54819 -107907 -106678 -1 662635
Discussion
questions
1. Comment on the short-term liquidity, longer term solvency and business
performance of Boat Builders based on your analysis of the ratios. Remember
that you should be analysing the modified financial statements that you gen-
erated as part of case study 1.
2. Comment on what your analysis of the cashflow budget has revealed.
Overall, do you see the cashflow budget as being pessimistic, optimistic or
realistic? Do you think that Boat Builders' request for an increase in bor-
rowing facilities is justified? In your opinion, will the business be able to
reduce its overdraft to below $110 000 by July 2004?
3. Based on your ratio analysis of the statement of financial position and state-
ment of financial performance, plus your analysis of the cash flow budget, do
you consider that Boat Builders is in a strong position as a borrower? As the
lender to Boat Builders, what are the major risks that you face?
I Casestudy2: Financialanalysisof BoalBuildersPly Ltd 511

Casestudy3 - OrbitalEngineCorporation
ltd*
learningobjectives
1. demonstrate a familiarity of the format of general-purpose financial accounts
for a listed company
2. demonstrate an understanding of the impact of company structures (that is,
company accounts versus consolidated accounts) on the analysis of first and
second ways out of the proposed loan
3. conduct a detailed analysis of the first and second ways out for a loan to a
listed company
4. produce a lending submission for the proposed loan (according to the
pro-forma provided) which clearly identifies the risks and risk mitigants
associated with the deal.
Introduction
This case study on Orbital Engine Corporation Ltd poses interesting challenges
for a lender. As a listed company on the Australian Stock Exchange, Orbital
produces detailed financials as part of its annual reports. Compared with Veter-
inary Clinic Pty Ltd (case study 4), Orbital offers an abundance of information.
For those relatively new to the experience of lending, it is easy to become
swamped by all this information. We suggest that if you start to feel over-
whelmed by the quantity of information, you should go back to basics and ask
the question: what are the first and second ways out for this loan?
This case study on Orbital Engine Corporation Ltd is different from other
case studies in this book in that it involves an actual business. The request for
funding, however, is hypothetical.
OrbitalEngineCorporation
ltd
Date: Tuesday, 30 October 2001
Background
Your are working as a corporate lending manager in a major bank. The board of the
bank decided at the start of the year that it wanted to increase the amount of cor-
porate lending business on its balance sheet (that is, its statement of financial pos-
ition). As part of the implementation of that decision, you and the other corporate
lending managers have been given ambitious monthly lending targets to meet.
You have been directed to meet your monthly targets by increasing both your
lending to your existing customers and your lending to new corporte customers.
Part of your typical week involves trying to identify existing and new companies
* Disclaimer: Thc lending proposition for Orhital in this case study is cntirely hypothetical.

to which you can make new laons. Orbital is one of the new companies that you
have identified as prospective customers.
A school friend, who went on to do study engineering, is currently working
with Orbital. Through him, you have learned that Orbital has successfully
granted licence rights to manufacture products incorporating Orbital tech-
nology to some of the major automotive, marine and motorcycle manufacturers
in the world. Manufacturers that currently sell products with Orbital tech-
nology include Mercury Marine, Tohatsu, Bombardier and Aprilia.
Orbital Engine Corporation Ltd is a company that was first listed (as Sarich
Technologies) on the Australian Stock Exchange in 1984. Orbital has described
itself as:
... an intellectual property company that has developed world leading direct fuel
injection, combustion and control system technologies collectively termed the
Orbital Combustion Process (OCPTM).When applied to either 2-stroke or 4-stroke
internal combustion engines, OCpTM achieves a superior combination of fuel
economy improvement and emissions reduction and is suitable for automotive,
marine, recreational, motorcycle and scooter applications ... (www.orbeng.com.au/
orbitaliaboutOrbitaliaboutOrbital.htm, 19 October 2001)
Lendingproposition
Your brief reading of the Orbital annual report has identified that Orbital is
effectively 100 per cent equity funded. Avoiding debt funding has been a delib-
erate decision of the Orbital board. Your thinking, however, is that while pure
equity funding might have been appropriate while Orbital developed its tech-
nology, it may not be as appropriate now, given the company's new phase of
granting licence rights to major manufacturers.
You have decided to expolore the possibility of putting a proposal to Orbital
to take on some debt funding. You have in mind that a $5 million five-year
multi-option faCility may be appropriate. This faCility would allow Orbital to
drawdown up to $5 million in different forms (including commercial bills, cash
advances and so on).
Before you put the proposal to Orbital, you need to do some detailed credit
analYSis of the posposed $5 million exposure. You know there will be both
strengths and weaknesses associated with the proposed Orbital exposures, as
with any lending. Your task is to see whether there is a way of structuring the
deal to ensure the bank mitigates against the deal's weaknesses (or risks). You
may not be able to find such a way, but at least you should do as much thinking
and analysis as you can to see whether a viable loan can be structured.
The following information is relevant to your analysis of the proposed
Orbital exposure:
• The Orbital website (http://www.orbeng.com.au/orbitallhomelhome.htm) has
a copy of the recently released 2001 Annual Report. The format of this annual
report is typical for a listed company, in that it provides an overview of the
company's operations, then detailed financial statements.
• A cashflow budget for 2002 is not available to you as part of your analysis.
I Ltd 513
Casestudy3: OrbitalEngineCorporation
• The only assets available for security are those listed on the company's
statement of financial posltlon. Some of these assets have already been
provided elsewhese as security. Details are provided in the notes to the
financial statements.
For the purpose of this case study, you are asked to structure your analysis in
the form of a written lending submission. The submission will end with a
recommendation on whether you wish to proceed with this proposed exposure.
The format you will use for your lending submission is the standard format
used by Excel Bank. This structure has a number of attractive features. One is
that the analysis of the financials is done in the appendixes to the submission.
This allows you to conduct this analysis before writing the submission. As a
result, the submission tends to benefit from a sense of 'hindsight'. It also means
less of a tendency for the submission to be clogged with numerical analysis,
which is relegated to the appendixes.
Your aim is for the submission to contain, in the case of the financial
analysis, only those issues that are absolutely central to the deal. Another
attractive feature of the Excel Bank submission format is the clear focus on
identifying the deal's key risks and how these key risks relate to the ultimate
decision.
Excel Bank format for a lending submission
Background detail What is the name of the borrower? What is their address? Who are the
major shareholders/unit holderslbeneficiaries?
Brief overview of What is the deal? How much is being borrowed? For what particular
the facts of the deal purpose? Over what period of time?
Overview of the What are the current borrowings (if an existing borrower)? What is the
borrower history of this borrower? If the borrower is not an individual, then who
are the individuals behind the borrower? What does the borrower do to
generate income? What are some of the key characteristics of the
business (number of employees, products, location, number of
competitors, management, marketing and so on)? How has the business
changed over time?
Industry analysis A commentary on the industry, ending with a statement about the key
success factors and key sensitivities of this industry
Financial analysis The key credit issues to come out of the financial analysis in appendixes
2 and 3
Security Identification of the key credit issues that come out of the existing
security structure, as per the analysis in appendix 1. A concluding
comment should be made about the strength of the second way out.
Key strengths and This section will draw on the analysis provided in the preceding sections
weaknesses and appendixes. Ways of mitigating risks should be identified where
(risks) ofthe deal possible. In both this section and the next, the strength of both the first
and second ways out for the proposed borrowing should be clearly noted
as either a strength or weakness.
Recommendation A clearly justified recommendation, including a list of relevant
covenants

Appendix 1 The security position. This appendix should detail the different items of
security and the lending margin that is available overall on this security.
Appendix 2 Analysis of the historical financials (statement of financial position,
statement of financial performance and cashflow statement). This
analysis should always focus on the ultimate identification of risks
(rather than on detailed quoting of numbers). Comments on the
statement of financial position and statement of financial performance
should be made under the broad headings of 'short-term liquidity',
'longer term solvency' and 'business performance'. A cashflow statement,
if not provided by the customer, may be generated by the lender and
discussed in this appendix.
Appendix 3 Analysis of the projected financials (cash flow budget projections and/or
statement of financial position and statement of financial performance).
Two key issues that need to be addressed in this section include whether
the amount sought is sufficient for the business's likely needs and
whether the business has the capacity to service/repay the proposed
borrowings. The five-stage cashflow checklist should be used in
analysing the cashflow budget.
Note: Orbital calls its statement of financial position a balance sheet, and it calls its statement of financial per-
formance a profit and loss statement.
In researching information for your assignment, your main source should be

Orbital's website at www.orbeng.com.au. There is also likely to be other infor-
mation available on the web that provides analysis of the operations of Orbital.
For the purpose of this case study, your working date is Tuesday 30 October
2001. If you are searching for information on Orbital (particularly from the
web), then you will need to restrict yourself to information that was publicly
available as at Tuesday 30 October 2001. You are not to contact Orbital directly
with any queries.
Discussion
questions
1. Two sets of accounts are provided in Orbital's 2001 Annual Report: accounts
for the company and accounts for the consolidated entity. In conceptual
terms, why are there differences between these two sets of accounts? In prac-
tical terms, what are some of the major differences between the consolidated
entity and the company? In analysing the proposed exposure to Orbital,
which set of financials would you analyse?
2. DistingUish between the concepts of business risk and financial risk. Com-
ment on the respective levels of business risk and financial risk faced by
Orbital. How do these two risk concepts relate to the board decision to be
purely equity funded?
I Casestudy3 OrbitalEngineCorporationLtd 515 I

Casestudy4 - Veterinary
ClinicPtyltd*
learningobjectives
1. complete a detailed analysis of a cashflow budget for a small business (using
a five-stage checklist)
2. conduct an analysis of the first and second ways out for a loan to a small
business
3. produce a clearly argued lending submission for a proposed loan to a small
business, which identifies the risks and risk mitigants associated with the
deal and makes a logical recommendation.
Introduction
Boat Builders Pty Ltd was a case study that required detailed analysis of state-
ments of financial position, statements of financial performance and a cash-
flow budget. In some real lending situations, however, the lender does not
have the luxury of a comprehensive set of financial statements to analyse.
Veterinary Clinic Pty Ltd is a hypothetical case that illustrates this practical
problem. The major area of analysis for the lender in the case of this business
is a cashflow budget and three years of statements of financial performance.
No statement of financial position is provided to support the loan application.
The lender's task mainly involves analysing in detail the cashflow budget and
then proceeding to an analysis of risk with the deal. Out of this analysis, a
detailed lending submission is required.
Veterinary
clinicproposal
Date: May 2003
Background
You work as a Relationship Manager in the Business Lending Division of
Excel Bank. Recently, Excel Bank conducted an advertising campaign designed
to increase its share of the business market in the State. In this advertising
campaign, various concessions on interest rates and fees have been offered to
any new business borrower or any existing business borrower that moves
across from any other lender to Excel Bank. Linda Davies and John Williams
have contacted you in response to this advertising campaign. They ring to
arrange a meeting to discuss the possibility of obtaining a business loan from
Excel Bank.
* Disclaimer: This case study is hypothetical. Any resemblance to actual events, locales, entities or persons is
I 516 Part7: Casestudies

Thecustomers
Linda Davies and John Williams have been retail customers of Excel Bank for
two years. All their accounts (including credit cards and two personal loans)
have been conducted satisfactorily over that time.
Linda and John are aged in their early 30s. They both finished their veter-
inary science degrees at the University of Melbourne at the end of 2000. Prior
to studying veterinary science, Linda studied a science degree at RMIT and John
studied commerce at the University of Western Australia. They met during
their veterinary studies and married during the final year of their course. They
do not have any children.
During 2001, they went on a working holiday around Australia. For eight
months they lived in Broome and worked in an established veterinary clinic
that is owned and operated by a family friend. Since returning to live in
Melbourne in February 2002, John and Linda have worked respectively in
suburban clinics located in the suburbs of Brunswick and Coburg. Both clinics
are approximately 10-15 kilometres north from the centre of Melbourne.
Linda has learned that the owner of the Coburg clinic, Cliff Costello, is
thinking about selling the business. He has not yet contacted a business
broker or advertised the business for sale, although he has indicated to Linda
that he may be willing to sell it to her.
Linda and John have a taxable income of $42000 and $44000 respectively
from their veterinary work.
Thedeal
Linda and John are seeking bank funding to help acquire the existing veterinary
clinic in Coburg. This acquisition includes the business and premises, for a
total cost of $750000 (business premises $400000; goodwill $290000; plant
and equipment $60000). The borrowing would be through the couple's com-
pany, Veterinary Clinic Pty Ltd.
Theexistingbusiness
History
The clinic is a small animal practice which Linda and John feel has been run in
a fairly 'laid back' way by Cliff Costello. Presently, Mr Costello attends on
Friday, Saturday, Sunday and Monday, which are the days of highest turnover.
Linda has been working at the clinic on Tuesday, Wednesday, Thursday, Friday
and Saturday.
Profile of Cliff Costello
Mr Costello is approximately 58 years old and appears to be 'comfortable' from
a financial point of view. He has been happy to work just four days per week
over the past five years, with an assistant in attendance on the other days.
Premises
The business is located in a general-purpose commercial building which has
been adapted for use as a veterinary clinic. These premises are approximately
15 years old and the external appearance is in reasonable condition.
I Casestudy4: VeterinaryClinicPtyLtd 517

Historical financial information
Mr Costello has provided a statement of financial performance for the previous
three years (page 519), but is unwilling to provide a statement of financial
position. His view is that the statement of financial position just shows how he
has financed the business, which is not relevant to Linda Davies and John
Williams' decision to buy the business. In any case, he feels confident that he
is selling a strong business at a good price, with or without the information
from the statement of financial position.
Theproposed
business
The cashflow projections for the proposed business are set out in the cashflow
budget on page 520. Linda and John employed their accountant to prepare
this cashflow budget. The accountant's view is that the cashflow budget is
realistic to the extent that it is based on the historical trading figures for the
business.
Security
The asset and liability position of Linda and John is as follows.
Assets Liabilities
Residence 265000 Mortgage 200000
Contents 26000
Motor Vehicle 9000
Cash 19000
Total assets 319000 Total liabilities 200000
Net assets 119000
Yourtask
You are required to produce a written lending submission for the proposed
borrowing by Veterinary Clinic Pty Ltd. Finish the submission with a recom-
mendation regarding whether you will fund the purchase of this business. It
may be that you decline to fund this proposed loan if you feel that it is not
possible to structure the deal in a way that satisfactorily mitigates the major
risks. If you decide to decline the deal, then you are still required to write a
full submission so your reasons for declining the deal are clearly developed
and explained.
For your lending submission, you will use the standard format provided by
Excel Bank. Case study 3 contains the standard format (pages 514-15) and its
advantages (page 514).
While the Veterinary Clinic Pty Ltd deal undoubtedly involves some prob-
lems (alongside some good reasons for taking on the businc:;s), you decide to
[518 Part7 Casestudies J

examine whether there is a way of structuring the deal that mmgates these
problems. You may be unable to find such a way, but at least you should do as
much thinking and analysis as you can to check whether a viable loan can be
structured.
Statement
offinancialperformance
01existingbusiness
(CliffCostello)
fortheyearended30 June2002 andprioryears
2000 2001 2002
Income
Veterinary fees 557331 601203 621184
Expenditure
Accountancy fees 2002 2454 2287
Advertising 961 2562 1963
Bank charges 3104 3323 3469
Electricity 3722 3487 2939
Insurance 2334 4501 4673
Laboratory fees 4277 6353 7103
Medical supplies 90316 106483 90396
Motor vehicle expenses 2884 3426 1885
Office expenses 503 211 2432
Rates, taxes and bUilding insurance 3492 4900 4502
Repairs and maintenance 1657 1039 1495
Seminars 976 800 1258
Subscriptions 1171 1266 805
Sundry expenses 1582 0 526
Super contributions - employees 1626 1961 4613
Surgery expenses 13400 13226 13060
Telephone 4596 4523 4397
Wages and locum fees 115189 132107 153751
Total expenditure 253792 292622 301 554
Net profit 303539 308581 319630
I Casestudy4 VeterinaryClinicPtyLtd 519 I

""
'"
=
"'C
'"
:::.
-.J
("")
'"
en
il Opening balance 0 11119 34280 45903 50563 64333 77769 95419 108258 120359 127472 150428
Cash inflow
Veterinary fee income 51409 65327 50699 55385 53255 52262 59362 51552 51267 44735 64190 50557 650000
Total cash inflow 51409 65327 50699 55385 53255 52262 59362 51552 51267 44735 64190 50557 650000
Cash outflow
Medical supplies (16% of fee income) 8225 10452 8112 8862 8521 8362 9498 8248 8203 7158 10270 8089 104000
Accounting fees 1250 1250 2500
Advertising and promotion 2,200 2200
Bank charges 300 300 300 300 300 300 300 300 300 300 300 300 3600
Electricity 500 500 500 500 500 500 3000
Insurance 4700 4700
Insurance - building 1100 1100
Laboratory fees 600 600 600 600 600 600 600 600 600 600 600 600 7200
MOlor vehicle running costs 200 200 200 200 200 200 200 200 200 200 200 200 2400
Office expenses 200 200 200 200 200 200 200 200 200 200 200 200 2400
Rates and taxes 4500 4500
Repairs and replacements 120 120 120 120 120 120 120 120 120 120 120 120 1440
Subscriptions and registrations 150 150 150 150 150 150 150 150 150 150 150 150 1800
Superannuation 375 375 375 375 375 375 375 375 375 375 375 375 4500
Surgery expenses 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 12000
Telephone 390 390 390 390 390 390 390 390 390 390 390 390 4680
Wages - staff 13 300 13300 13300 13300 13300 13300 13 300 13300 13300 13300 13300 13300 159600
Joint salary (Linda Davies andJohn Williams) 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 48000
Bank repayment (proposed $750000@ 10% 9829 9829 9829 9829 9829 9829 9829 9829 9829 9829 9829 9829 117948
over 120 months)
Interest on overdraft 0 0 0 0 0 0 0 0 0 0 0 0 0
Total outflow 40289 42166 39076 50726 39485 38826 41712 38712 39167 37622 41234 38553 487568
Net surplus/deficiency llll9 23161 11623 4660 13770 13436 17650 12840 12100 7113 22956 12004 162432
Bank balance 11lJ9 34280 45903 50563 64333 77769 95419 108258 120359 127472 150428 162432 162432
Accountant's disclaimer
This cash£low forecast has been prepared from the vendor's statement of financial performance (2000-02) and information supplied by my client. The figures as contained
herein have not been subject to any detailed examination hy us to determine whether those figures are considered reasonable. Accordingly, we do not express an opinion on
these figures, nor do we accept liability to any third party whatsoever.
Certified Practising Accountant
Discussion
questions
1. Mr Cliff Costello has declined to provide a statement of financial position for
the business. Comment on whether you feel this is a major disadvantage to
you in conducting your financial analysis of this deal.
2. Provide a detailed comment on your analysis of the cashflow budget. Do you
think the accountant has put much time into the creation of this cashflow
budget? Do you see this cashflow budget as being pessimistic, optimistic or
realistic? Do you think that the request for borrowing facilities is justified?
3. Compare the strengths and weaknesses of this deal with the Boat Builders Pty
Ltd deal. In your opinion, which is the stronger of the two deals? Explain.
I Casestudy4: VeterinaryClinicPtyLtd 521

Casestudy5 - Creditriskofmajor
Australianbanks
Learningobjectives
1. identify and explain a range of different measures of credit risk, including the
measure of impaired assets required by the Australian Prudential Regulation
Authority
2. use these different measures of credit risk to assess the credit risk taken by a
bank
3. conduct a major piece of analysis involving comparing and contrasting the
credit risks taken by two major Australian banks in recent years.
Introduction:
background
onthemajorAustralian
banks
There are four major Australian banks: the Australian and New Zealand
Banking Corporation (AN Z), the Commomvealth Bank of Australia (CBA),
the National Australia Bank (NAB), and the \Vestpac Banking Corporation
(WBC). The major banks arc so named because they currently dominate the
Australian banking system and have done so since the start of the twentieth
century. They currently account for two-thirds of the total assets of the
banking system. Their retail network accounts for 80 per cent of all bank
branches and allows them to dominate the retail banking market. Given
their activity in commercial and corporate lending, as well as retail lending,
they are often referred to as one-stop financial shops (or financial super-
markets).
Comparing
twomajorAustralian
banks
Although there are four major Australian banks, this case study requires you to
compare only two. Much detailed information is available on the credit quality
of each bank, so comparing the credit quality over time of two banks should
constitute a substantial case study exercise.
Make the comparison using the consolidated figures for the whole
banking group, rather than from the point of view of the individual bank
(which is sometimes referred to as the parent entity or the company). We
also suggest that you make the comparison using at least the past two years
of figures.
If you have time to extend the case study further, then consider including a
regional bank as a point of comparison. After the major banks, the three largest
regional or foreign-owned banks arc St George bank, Suncorp Metway and
BankWest. Each of these banks would make an interesting case for comparison
with the two major banks that you select.

Sourcing
information
fromtheannualreports
Each of the four major banks has a website that contains annual report infor-
mation. At the time of publication, the relevant information for accessing the
respective annual reports was as follows.
Web-based annual report information of major banks
Webpage
buttons10access
Bank(URL) annualreports Typesofannualreportsprovided
(asa PDFfile)
ANZ 'Investor relations' • 2001 Annual Report
(www.anz.com.au) 'Financial reports, • 2001 Financial Report
annual reports and
results'
Commonwealth 'Shareholder centre' • Concise Report to Shareholders 2001
(www.commbank.com.au) 'Annual reports' • Full Annual Report 2001
National Australia Bank 'About us' • Annual Review 2001 (concise financial
(www.national.com.au) 'Shareholders' centre' statements)
• Annual Financial Report 2001 (fully detailed
financial statements)
Westpac 'Westpac info' • 2001 Annual Report
(www.westpac.com.au) 'Investor information'
As indicated above, the majority of the major banks provide two types of
annual report. The first is called a concise report, a concise annual report or
just an annual report. The second is called a financial report, full annual
report or annual financial report. Access the second report for this case
study, because it contains the detailed notes to the financial statements.
Included among those notes are three or four that relate to the bank's credit
quality. Using Westpac's 2001 Annual Report as an example, the notes are as
follows: Note 13 - loans; Note 14 - provisions for bad and doubtful debts;
Note 15 - impaired assets; and Note 30 - credit risk concentrations. These
notes provide detailed quantitative information about the bank's credit risk
position.
Each bank prepares information on impaired assets in response to a
requirement of the Australian Prudential Regulation Authority. Detailed
information on the requirements for reporting impaired assets is contained
in Prudential Standard APS 220, Credit Quality and also in Guidance Note
AGN 220.1, Impaired Asset Definitions. This prudential standard and the
associated guidance note can be accessed at the authority's website,
www.apra.gov.au.
In addition to the notes to the financial statements, most annual reports con-
tain other discussions of the credit risk position of the bank.
These full financial reports are all available in PDF format. You have a
choice of printing a copy of each document or working from the page images
on the screen. These full reports are large documents that typically are over
fifty pages.
Casestudy5: Creditrisk of majorAustralianbanks 523 I

Othersourcesofinformation
In addition to the annual reports, it should be possible to access other relevant
information, particularly information that is available on the Internet. The
following are examples of this type of information.
• The accounting firm KPMG produces an annual Financial Institutions
Performance Survey. The report is provided electronically and free of charge
at the website www.kpmg.com.au. This survey includes a detailed discussion
and comparison of the credit risk positions of the major banks.
• The Australian Prudential Regulation Authority produces a quarterly
publication that is entitled APRA InSight. The report combines prudential
commentary and feature articles with a set of statistical tables and figures.
The statistical tables include detailed information on the credit quality of
the major banks.
Howto structure
thecomparison
For comparing the credit risk of two major banks, we suggest that you use the
following broad headings and associated questions.
Part A: An overview of each bank
What are the major characteristics of each bank? How successful has each bank
been over the past five years? What do you see as the strategic direction that the
board of each bank has set for the next five years?
Part B: Analysis of credit risk
What are some of the different ways in which credit risk has been measured in
the available information? How are the two banks similar ancl/or different in
terms of their respective overall levels of credit risk? Why do these similarities/
differences exist between the two banks?
Part C: Conclusion
How can these similarities/differences be related back to underlying similarities/
differences in the management of these two banks? Would it be reasonable to
expect these similarities/differences in credit risk to continue over the next five
years?
Discussion
questions
1. Explain the structure and purpose of the impaired assets return that banks
and other approved deposit-taking intermediaries (ADIs) provide to the
Australian Prudential Regulation Authority. Do you think that this return
provides an accurate overview of credit risk?
2. Is there any difference in the credit risk taken by each major bank in its
Australian operations compared with its overseas operations?
3. Relate your analysis of the credit risks taken by each major bank to the
performance of that bank as measured by its share price.

acceptance rate: The fraction of the total banker's lien: The right of the lender (creditor),
number of applications that are accepted in possession of the goods or security of the
(p.1 04) debtor, to retain those goods/security until the
accounting rate of return: A measure of the debt is fully repaid together with interest
earnings from a project - usually after both (p.219)
depreciation and income tax are deducted - bankruptcy: Inability to repay debt; also called
expressed as a percentage of the investment insolvency (p. 150)
outlay (p. 63) Basel II: The proposed new capital adequacy
acquirer: The local bank of the merchant (p. 144) guidelines (p. 382)
ad valorem: According to value (p. 216) BECS: The Bulk Electronic Clearing System,
adverse selection: In the context of a lender which processes large-volume electronic
increasing interest rates on a loan product, an credit and debit transfers (p. 419)
incentive for better quality customers to leave behavioural scoring models: Models that use
in search of lower borrowing costs while the data built up from a customer's behaviour
poorer quality customers remain (p. 286) over time instead of static application details
Altman 'Z' score: A benchmark score devel- (p.96)
oped through multivariate analysis (p. 337) benefit-cost ratio: A ratio of the present worth
APCS: The Australian Paper Clearing System, of benefits and the present worth of costs
which clears cheques and also other paper (p.63)
instruments (p. 419) bill finance: A form of financing involving the use
asset mix: The mix of products offered by an of a discount security called a bill/commercial
institution, which allows for diversification of bill/bank bill. The bill is issued at a discount on
funding sources and income streams (p. 243) its face value and the borrower is obliged to
assignment: A transfer of a right, property or pay the face value at the time of maturity,
debt by one person (assignor) to another which is usually in around ninety days. (p. 269)
person (assignee) (p. 213) break-even: A 'no profit, no loss' position, repre-
asymmetric information: A reference to the senting the level of units that need to be pro-
distribution of information between borrower duced and sold to cover all costs (p. 48)
and lender being unfavourable to the borrower business cycle: The identification of a cycle of
(p.286) economic activity (p. 391)
ATM: Automatic teller machines, which automate business performance: A measure of a busi-
two functions: deposits and cash extraction ness's profitability (p. 296)
(p.416) call option: The right, but not the obligation, to
authentication: Methods used to verify the buy an asset (p. 342)
identity and authorisation of customers capital: The funding of the business provided by
(p.436) the owners. It has the properties of being
back-to-back loan: The use of one loan as the available to meet losses, permanent and free
security for another in the loan approval of fixed financing charges. It is also known as
process (p. 253) equity or shareholders' funds. (p. 289)
BACS: The Banks Automated Clearing System, capital adequacy: Regulation that requires
which banks use for the settlement of trans- financial institutions to put aside capital for
actions (p. 416) each loan they approve (p. 371)
bad debt write-off: Permanently writing off bad cash break-even point: The level of output that
debts against the balance sheet (p. 396) needs to be produced and sold to meet not
bad loans: Cases or propositions that would not only the fixed costs but also the loan instal-
be approved for credit in hindsight (p. 90) ment together with interest. It is calculated by
bank guarantee: The process whereby a bank dividing the fixed costs plus loan instalment
or financial institution superimposes its credit- together with interest minus depreciation by
worthiness for that of its client (p. 330) contribution per unit. (p. 68)
cash rate: The key money market interest rate, credit approval models: The models that are
which the Reserve Bank of Australia controls. used, by themselves or in conjuction with a
Changes to the cash rate are used to judgemental system, for approving consumer
implement monetary policy. (p. 270) credit (p. 96)
cashflow: Refers to payment and receipt of credit assessment: An assessment of the credit
money in cash (p. 243) risk associated with a loan. In the case of most
cashflow budget: A statement of expected small business borrowers, this involves the
cashflows over a future period. The period is analysis of financial statements and the identi-
usually one year and the cashflows are stated fication of risks involved in the borrowing.
on a monthly basis. A realistic cashflow (p.275)
budget can indicate the borrower's ability to credit culture: A stratum of linked attitudes,
repay a debt. (p. 299) responses and behavioural patterns within an
i. cashflow projection: A cashflow budget (p. 299) organisation (p. 4)
cashflow statement: A statement of cashflows credit default swap: A swap that protects credit
over a given period (usually historical, in the risk in return for a fee over a period of time
sense that it applies to the year past). The (p.355)
statement has a standard format. (p. 299) credit derivatives: A class of derivatives that
central management: An alternative to a relation- deals with credit risk. (p. 352)
ship managed approach, often involving no credit event: An event that determines action
face-to-face contact between the lender and
under a credit derivative (p. 355)
the borrower. In some cases, central manage-
I' credit migration: The dynamic characteristic of
ment can involve the use of credit scoring
credit risk, whereby it will change over time
models. (p. 273)
(pp. 110, 348)
CHAPS: The Clearing House Automated Payment
credit options: Options that protect credit risk
System for electronic clearing (settlement) of
for an upfront fee (p. 355)
transactions (p. 416)
credit rating: An opinion of the general credit-
clean sale: A sale of lending assets where no risk
worthiness of an obligor, or an obligor's
or claim can be made on the selling organ-
isation (p. 375) creditworthiness with respect to a particular
collateral: Underlying security for a loan (liter-
debt (p. 378)
ally, 'along side') (pp. 5, 111, 146) credit rating agency: An agency that evaluates
common-size statements: The components of the credit status of an organisation and pro-
the balance sheet and the income statement vides a publicly available rating. Standard &
expressed as a percentage of total assets Poor's and Moody's are examples of credit
and total revenue respectively (p. 49) rating agencies. (p. 254)
communications strategy: A strategy or plan of credit rationing: The situation that can occur in
action for conveying information to customers loan markets where the point of market equi-
about the company and its products (p. 444) librium involves demand being greater than
I' competitor analysis: Analysis of the strength

and weaknesses of competitors (p. 444)
concentration risk: Risk that occurs when lending
is exposed to one style of borrower (p. 336)
supply and credit having to be rationed. This
is the consequence of information asym-
metries between borrowers and lenders.
(p.286)
continuing guarantee: A guarantee that covers credit risk: The potential for the loan principal
a series of transactions (p. 213) and interest repayments to not be paid in a
coordination problem: The hold-up of a loan timely manner (p. 109)
restructure because a debt holder demands credit scoring: A system of processing loan
to receive full repayment rather than a part applications by assigning scores to certain
repayment (p. 403) relevant variables (pp. 17, 89, 149, 275)
country risk analysis: The likelihood that unex- credit scoring model: A statistical model into
pected events within a host country will influ- which various pieces of information about a
ence a customer's or government's ability to prospective borrower are inputs. The output
repay a loan. Country risk can be divided into of the model is a single credit score that
sovereign risk and foreign exchange risk. measures the likely future loan performance
(p.31 2) of the borrower. (p. 302)
CreditMetrics™: A method for determining the dynamic provisioning: A method of smoothing
value at risk of a lending portfolio (p. 345) the lender's earnings volatility caused by
cross-sectional techniques: Techniques that problem loans (p. 393)
involve the analysis of financial statements at econometrics: A branch of economics that
a point in time (p. 49) assesses the mathematical relationship
cumulative default probability: Risk premium between economic variables (p. 110)
default assessed over time (p. 117) EDI: Electronic data interchange, which is the
data integration: Ensuring in-transit information inter-process communication (computer appli-
or in-storage information is not altered without cation to computer application) of business
authorisation (p. 437) information in a standardised electronic
dealer panel: A group of banks appointed by format (p. 418)
debt issuers to place their securities (p. 484) efficiency ratios: Measures of how efficiently
debt covenants: Terms and conditions included the business has employed its assets (p. 49)
in a loan contract, such as fees, security, EFTPOS: Electronic funds transfer at the point
insurance and stamp duty (p. 37) of sale (p. 415)
debt-equity ratio: A measure of leverage calcu- encumbrance: A right or interest in a property
lated by dividing debt (borrowed funds) by held by one who is not the legal owner of the
equity (own funds) (p. 57) property (pp. 178, 222)
default pOint: Defined in the expected default equipment leasing: A contract under which a
frequency method as short-term liabilities plus lessor hires out specific equipment to a
half the long-term liabilitiies (p. 342) lessee (p. 32)
delivery system: Various modes of distribution equitable mortgage: Mortgage by deposit of
of financial services (p. 444) title deeds (p. 213)
demographic factors: Factors that describe the equity participation: A method of financing
characteristics of population, such as distri- whereby the lending institution supplies equity
bution according to age, occupation and capital to satisfy long-term financing needs
gender (p. 446) (p.31)
deregulation: A process of dismantling the expected default frequency: Use of option
regulations that restrict the operations of theory to predict the probability of credit
financial institutions (p. 92) default, measured as the distance to default
direct finance: The process of financial inter- (pp. 123, 341)
mediation that does not include ownership expert systems: Credit risk assessment systems
transformation (p. 480) that rely primarily on human judgement (p. 110)
direct loan: A loan by one corporate to another, factoring: The purchase of debts by a lending
thus bypassing the financial institutions or institution (p. 32)
intermediaries (p. 253) fee-based income: Income from loans that is
discounted cashflow: The present worth of a not derived from the interest spread (p. 483)
future cashflow (p. 63) fee simple interest: A freehold interest in
discriminant analysis: A statistical method that property that is the highest bundle of rights a
distinguishes two populations of a sample person may enjoy in real property (pp. 177,
using characteristics (p. 120) 222)
discrimination: Denial of credit on the grounds financial intermediation: The process by which
of religion, race, sex, nationality and so on deposit-taking institutions raise funds from
(p. 161) surpus units (investors/savers) and lend those
distribution channels: Delivery systems funds to deficit units (borrowers) (p. 480)
(p.443) first way out: Normally, the cashflow from the
durability: The characteristic of an asset (a borrower's operations (p. 288)
security) whereby it lasts longer or does not five Cs: An expert system for credit risk assess-
deteriorate over time (p. 11) ment, covering character, capital, capacity,
duration: The term to maturity weighted by pres- collateral and conditions (pp. 6, 110, 245)
ent values (p. 346) fixed rate finance: Loans where the interest
duress: Compulsion; forcible restraint of liberty rate charged is fixed for the life of the loan
(p.224) (p.269)
floating rate finance: Loans where the interest indirect finance: Also called the indicator
rate charged can vary over the life of the loan lending rate, the process of financial inter-
(p.269) mediation that includes ownership transform-
foreclosure: The right to become a full owner of ation (p. 480)
the mortgaged property in the event of the informationally opaque: A description of the
borrower's inability to pay the debt (p. 222) information asymmetries inherent in lending to
franchising: The commercial arrangement small business. A small business is informa-
whereby a company grants a retailer an tionally opaque to the extent that the lender is
exclusive right to retail its goods in a specified unable to 'see into' the business and fully
area (p. 143) understand the credit risks involved. (p. 286)
freehold interest: An interest (a bundle of insolvent: A person who is unable to satisfy
rights) in a property that has no time limit debt claims; a bankrupt (p. 207)
(permanent in nature) (pp. 177, 222) interbank market: A facility for effecting trans-
fully drawn advance: A form of floating rate actions between financial institutions in dif-
finance where the amount borrowed is fully ferent countries. (p. 312)
drawn at the outset and then systematically intercompany loan: Loan by one division of a
repaid over the life of the loan (p. 269) company to another, usually on a short-term
garbage in, garbage out (GIGO): A reference to basis (p. 253)
financial analysis where the conclusions interest coverage ratio: The ratio of earnings
reached are of little value because the quality before interest and taxes to debt interest (p. 57)
of the financial statements used is so unrepre- interest spread: The difference between the
sentative of the business's real position (p. 295) deposit and lending interest rates (p. 483)
general provisions: Profits set aside against intermediation: A financing process whereby
general problem loans (p. 395) deposit-taking institutions raise funds that
geographic cluster: A grouping of households they lend to borrowers (p. 312)
according to geographic areas (p. 445) internal rate of return: The rate of return that
good loans: Cases or propositions that would equates the present value of the project's net
be approved for credit in hindsight (p. 90) cashflows with its initial cash outlay (p. 63)
guarantee: A promise to discharge another international credit evaluation: The process of
person's liability, such as a debt (p. 210) credit analysis that accounts for the different
hard information: Information about a business processes needed for lending money across
that is easy to quantify and communicate country borders and in different jurisdictions
(p.287) (p.31 3)
hereditaments: Things that are capable of being international financial system: A system of
inherited. Land, streams, trees, minerals, financial transactions that occur across
buildings, fences and other features perma- country borders involving the creation, sale or
nently in place on the land are interpreted as transfer of financial assets (p. 312)
real estate, or hereditaments (p. 177) joint tenancy: A type of freehold interest
hurt money: The borrower's contribution towards whereby any number of partners can own an
the project for which funding is requested. It is equal and undivided interest in the property
usually the first source of funds before lenders (p.1 77)
make a contribution (p. 244) judgemental decision-making: In the context of
hybrid systems: A combination of financial credit approval, decision-making based on
theory and economic statistics (p. 110) human judgement. Credit applications of appli-
impaired assets: A loan that is not receiving full cants with stable employment alone, for
interest and principal repayments in a timely example, may be approved without the appli-
manner (p. 391) cant fulfilling other credit aproval model cri-
indicator lending rate: The rate used to quan- teria. (p. 91)
tify the cost of funds to the lending institution. key person risk: The risk in lending to a busi-
Lending to any small business borrower is ness that can result from the key person in
usually done at a margin over the indicator the business (usually the owner) being unable
rate; that margin reflects the level of credit to continue working (usually as a result of ill-
risk involved. (pp. 37, 270) ness, injury or death) (p. 289)
large exposures: Lending more than 10 per cent margin lending: Loans for the purchase of shares
of one's capital base to an entity (p. 371) (p. 141)
larger national banks: A group of banks in the margin of safety: The difference between
United States that are likely to become domi- actual sales and break-even sales (p. 48)
nant in the small business lending market market segmentation: Classification of a market
through their introduction of credit scoring into different sectors for ease of analysis (p. 445)
systems (p. 288) marketability: The characteristic of a security
leasehold interest: An interest in a property that whereby it can be sold quickly (p. 11)
is held for a limited or fixed length of time maturity: The term of a loan or bond (p. 176)
(pp. 177,222) mild financial distress: Where a firm misses
lending criteria: The standards applied by a a repayment, but is worth more than the
financial institution to decide whether to borrowings (p. 399)
approve a loan (p. 242) minor: A person who has not attained 18 years
lessee: A tenant (p. 177) of age (p. 207)
lessor: A landlord (p. 177) moderate financial distress: Where a firm
leverage ratios: Ratios that show the extent of misses a repayment, but is worth more than the
debt financing used by a firm (p. 49) borrowings if remedial action is taken (p. 399)
lien: A charge against a specific property moral hazard: In the context of loan markets,
whereby the property is made the security for poor lending decisions using depositors'
the performance of a certain act, usually the funds. An increase in interest rates charged
repayment of a debt (pp. 178, 222) by a lender, for example, can lead existing
lifecycle: The period of the loan from approval borrowers to look for higher risk projects in
to repayment, which may be long term and which to invest. (pp. 286, 372)
involve several funding cycles (p. 242) mortality: Measures of the degradation of the
liquidation: The selling of assets from a dis- value of a debt over time (p. 123)
tressed borrower (p. 393) mortgage: A pledge of real estate as collateral
liquidity ratios: An arithmetic relationship to secure the promise made in the promissory
between two variables that measures the note (p. 175)
ability of the business to meet short-term obli- mortgage deed: An instrument for the transfer
gations. Two important ratios that measure of an interest in specific immovable property
such an ability are the current ratio and the to secure a loan (p. 213)
quick ratio. (p. 49) mortgage insurance: Insurance that protects
loan portfolio: The mix of assets that is under the lender in case of loan default (but the
management by an individual or institution applicant pays the premium) (p. 176)
(pp. 92, 242) multiple regression: The classical economic
loan syndication: A loan set-up where two or model that seeks to minimise errors (p. 120)
more lenders jOintly meet the large financial negative pledge: An undertaking by the borrower
needs of a corporate customer (p. 32) to not provide further security to another lender
loan-to-value ratio (LVR): Example: if the value or to do so on only a restricted basis (p. 37)
of a house is $100 000 and a loan of $80000 net present value: Initial outlay, or the present
is granted, then the LVR is 80 per cent. value of net cash flows (p. 63)
(p.141) nonrepudiation: Creating evidence of the origin
logit analysis: The lognormal version of probit and delivery of an electronic transaction
analysis (p. 122) (p.436)
longer term solvency: A measure of how ade- ombudsman: A dispute resolution authority
quately the business is funded via share- (p.228)
holders' funds (p. 296) option modelling: Development of a model for
management information systems: The means pricing options (p. 341)
of gathering and using information to help overdraft: A form of lending where the borrower
management decision-making (p. 96) is able to write cheques up to, but not
margin call: A stockbroker's call for payment exceeding, an agreed limit on an account. A
when the market value of the shares goes floating rate of interest applies to any over-
down, so as to restore the LVR (p. 141) draft borrowings. (pp. 28, 140,269)
PARSER: An expert system for credit risk rating agencies: Organisations that indepen-
assessment (pp. 115, 245) dently assess the creditworthiness of a
pass through: A securitisation structure that country or corporate, usually in cooperation
sells assets cleanly from the balance sheet with the entity that is being assessed. These
(p.353) agencies allocate a rating (alphabetical,
pay through: A securitisation structure that sells numerical or a combination of both) and then
cashflows (but not assets) from the balance on-sell the information to other interested par-
sheet (p. 353) ties for a profit. (p. 314)
payback period: The time it takes for the initial rating systems: A system that involves
cash outlay on a project to be recovered from assigning codes to the creditworthiness of a
the project's net cashflows (p. 63) borrower (p. 17)
PIN: Personal identification number (p. 418) ratio analysis: A technique of establishing an
principles of lending: The general criteria or arithmetical relationship between two figures,
elements that guide the decision-making of to help draw useful inferences (p. 49)
lenders (p. 242) real estate: The earth, the land and all natural
prime lending rate: Another name for an indi- and human-made hereditaments found per-
cator rate. It is so named because usually manently attached (p. 177)
only the most secure borrowers are able to recourse: The legal imperative that an institution
borrow at the prime rate. All other borrowers has to take back an asset that it has sold
are charged some risk margin over this rate. (p.375)
(p.270) regression: A statistical measure to fit a line
portability: The characteristic of a security through a set of observations. It is used to
whereby it can be transported and sold in analyse how a single dependent variable is
another market (p. 11) affected by the values of one or more inde-
probability: The proportion of times or chance pendent variables. (p. 99)
that some event may occur (p. 89) regression analysis: see regression (p. 120)
probit analysis: A regression that uses 0 or 1 relationship manager: An employee of a finan-
for its dependent variable to measure a 'yes' cial institution who is responsible for man-
or 'no' answer (p. 121) aging a portfolio of loans. The relationship
product development: The creation of new manager looks to develop a relationship with
product or services (p. 444) each borrower over a period of time and, in
profitability: The return to a financial institution the process, gains information about the bor-
on a transaction (p. 326) rower that can aid in the assessment and
profitability ratios: Measures of a business's management of the credit risk. (p. 272)
profitability. A financially sound business is residentially secured loans: Loans where the
likely to be a profitable business. The two security is a residence (typically, the resi-
popular profitability ratios are the gross profit dence of the borrower) (p. 275)
ratio and the net profit ratio. (p. 49) retail market: A market that caters mainly to
promissory note: A basic loan document that households and small businesses (p. 445)
contains a promise (express or implied) to right to set-off: A right that enables a bank to
repay the loan with or without interest (p. 213) adjust wholly or in part a debit balance in a
provisions: Profits set aside in case a loan is customer's account with any balance in his/
not repaid (p. 395) her credit (p. 219)
prudential regulation: A form of regulation risk capital: Capital that financial institutions are
whereby financial institution management must required to hold as a percentage of their
work within guidelines provided to them (p. 371) risk-weighted assets (p. 176)
put option: The right, but not the obligation, to risk premium: The difference between the
sell an asset (p. 342) interest rates of company debt and govern-
ranking: The process of giving numbers to data ment debt (pp. 37, 110)
set according to relative size. Loan appli- risk-adjusted return on capital: A method for
cations with a very high credit rating may be allocating capital on loans (p. 345)
ranked number 1 and so on, in descending RITS: Reserve Bank Information and Transfer
order of credit rating. (p. 89) System (p. 419)
RTGS: Real time gross settlement, which is a soft spots: A reference to debtors, creditors and
system for the settlement of high-value trans- stock in the balance sheet because they are
actions (p. 419) relatively easily manipulated (p. 296)
safety: The probability of repayment (p. 326) specific guarantee: A guarantee that covers a
second way out: Normally, security. Security single transaction (p. 213)
should be considered only after the first way specific provisions: Profits set aside against a
out of the loan (cashflow from operations) has specific borrower (p. 395)
been analysed in detail. (p. 288) statistical: Based on analysis of data. 'Statis-
securitisation: The packaging of cashflows tical evidence', for example, means evidence
(p.352) derived from data analysis. (p. 89)
security: Collateral for a loan. It can take a step-down approach: A method of analysis for
number of different forms. Residential an international lending transaction that
security is the form favoured by many small ensures the application is handled in the
business lenders. (p. 271) most efficient and time-bounded manner. The
segment: A portion of the loan portfolio (p. 242) analYSis occurs from the macro level to the
sensitivity: The stress testing of a project. It micro level, enabling a withdrawal from the
involves assessing the effects of changes or transaction in a staged manner. (p. 315)
errors in the estimated variables on the net stored value card: A payment instrument on which
present value of a project. (p. 48) a value is stored. The cards can be used to
severe financial distress: Where a borrower's make payments up to the stored value. (p. 414)
economic value is less than its borrowings structuring: Setting the loan repayment pat-
(p.399) terns and other terms to be agreed between
Sharpe Index: Risk-adjusted return (p. 345) the bank and the borrower (p. 168)
short-term liquidity: A measure of the ability suitability: The acceptability of the transaction
of a business to manage its liquidity via for the culture of the lending institution (p. 326)
movements in current assets and current SWIFT: Society for Worldwide Interbank Funds
liabilities (p. 296) Transfer (p. 416)
Simulation: A technique of creating scenarios technology: Generally, computers, visual and
to analyse many aspects of the risks of a audio communication systems and other
project (p. 65) information technology (p. 89)
small business: According to the Reserve Bank tenancy in common: The possibility of many
of Australia, a business that has loans of less partners holding an undivided but not neces-
than $500 000. The Australian Bureau of sarily equal share of interest in the property
Statistics defines a small business as having (pp. 177, 222)
fewer than twenty employees. (p. 267) term structure of interest rates: Yields that are
small proprietary company: A category of analysed at a single point time for various
company under the Corporate Simplification maturities for a single issuer (p. 115)
Act 1995 that is not required to provide tier 1 capital: Capital that is considered perma-
detailed financial statements. Most small nent in nature (p. 372)
businesses qualify as small proprietary com- tier 2 capital: Capital that has features that
panies under the Act. (p. 292) result in it being less permanent in nature
smaller community banks: A group of banks in (p.372)
the United States that have traditionally domi- time series techniques: Analysis of financial
nated the market for small business lending information such as ratios over a period of
through their community focus and use of a time. Current ratios of a firm for the past five
relationship lending model (p. 288) or ten years may be presented, for example,
SMEs: Small to medium-sized enterprises (p. 93) to compare the trend. (p. 49)
soft information: Information about a business Torrens mortgage: A mortgage that takes the
that is difficult to quantify, substantiate and form of a statutory instrument which, when
communicate. An example would be infor- registered, confers on the mortgagee an
mation about the character of a borrower. One interest in the land (p. 213)
role of a relationship manager is to gather soft total return swap: A swap that protects credit
information about borrowers. (p. 287) risk in return for funding payments (p. 355)
trade finance: Sellers of goods or services window dressing: The covering up of facts to
usually allow the buyer a grace period for show a rosy financial picture. A company may
making payment. Where such time is not not show certain expenses (depreciation), for
allowed by sellers, banks may give a loan example, to boost profit figures or reduce
(trade finance) to enable the buyer to make losses. (p. 73)
immediate payment to the seller. (p. 312) working capital: The net difference between
value added network: A network that facili- current assets and current liabilities (p. 257)
tates the exchange of electronic data by yield curve: A curve that depicts the term
accepting data in a variety of formats and structure of interest rates. The most
converting the incoming data into a format commonly used yield curve in financial
that the receiver of the information can use markets is for Commonwealth Government
(p.41 8) securities. It plots the yields on these
WAP: Interconnected computers that cover large securities as a function of their respective
geographic distances (p. 420) maturities. (p. 271)
wholesale market: A market that caters mainly zone of ignorance: Inconclusive Z score range
to institutions or large companies (p. 445) (p.340)
,I
ability 9 Australian Securities and Investment Commission
acceptance rates 104 Act 1989 20, 161,229
accounting-based systems 95 Australian Securities and Investments
accounting rate of retum 63 Commission 141-2,161-2,229-30
acquirer 144 authentication 436
ad valorem duty 216,217 authorisation of controls 437
advanced regression analysis 121-2 authorisation scores 98
advances average collection period 55-6
characteristics of different types 28-33
modern types for businesses 31-3 back-to-back credits 322
structuring 37-8 back-to-back loans 253
traditional types 29-31 bad debt write-offs 396
advances portfolio, designing 39 bad debts, and banks share prices 392
adverse selection effect 286 bad loans 90, 393, 406-7
advertising 469, 470-2 balance confirmation letters 217
balance sheet 46, 291
budget 472
balance sheet costs 359
content and presentation 471
bank fees 38, 168, 195, 210
measuring effectiveness 472
and small business 277-9
media planning 471
bank guarantees 330-1
objectives 470
bank lending 481-2
Altman's Sharpe Index 345, 347-8
bank marketing, definition 443
Altman's Z score 128, 337-41
bankers' acceptance market 324
anti-discrimination laws 161,225-7
Bankers Automated Clearing System (BACS) 416
application credit scoring models 97
banker's lien 219-20
application derivatives 97-8
Banking Act 1959 20
application fee 38
bankruptcy 150
appropriate payments, right to 220
Bankruptcy Act 227-8
asset mix 243
Basel Committee of the Bank for International
assignment of shares or life policies 213, 214-15 Settlements (Basel II) 372, 382-3
asymmetric information 286 and regional banks 383-4
ATMs (automatic teller machines) 416, 421, 433, 466 e-banking risk management issues 435-7
attrition models 98 internal ratings system for allocating credit 383
audit trails 437 behavioural aspects of credit scoring 91-2
Australian Bankers Association 161, 228 behavioural scoring models 96
Australian Banking Industry Ombudsman 228-9 benefit-cost ratio 65
Australian Competition and Consumer bill finance 271-2
Commission 20, 145,229 bill of sale 214
Australian Paper Clearing System (APCS) 419 board and management, electronic banking 435-6
Australian Payments Clearing Association Boat Builders Pty Ltd
(APCA) 419 case study 499-506
Australian Prudential Regulation Authority 20, 371 financial analysis, case study 507-11
and problem loans 394-5 Bond Corporation 76-7
capital adequacy 372 'book up' 141-2
credit directives 376-7 borrower-specific factors 20-1
general provisioning 395 borrowers
large credit exposures 374-5 business 35-6
securitisation 375 personal 33-4
views on Basel II capital standards 383-4 special types 36
Boston Consulting Group 438 clubs 36
BPAY 419 Code of Banking Practice 161,228
break-even analysis 66-8 coercion 224-5
cash break-even point 68-9 collateral 5, 11, 48, 112-13, 126
margin of safety 68 consumer loans 148
break-even sales 48 corporate loans 246
Bulk Electronic Clearing System (BECS) 419 personal loans 153
Burns Philp's restructure 404-5 collateral advantages 329
business borrowers 35-6 collection models 98
character assessment 9 commercial credit score 79-80
NAB checklist 23 commercial lending decision-making process 248
options open for 12-16 common-size statements 59-60
business cycle 393 communications strategy 468-70
boom 394 advertising 469, 470-2
downturn 394 personal selling 469, 472
recovery and expansion 393 promotion 469, 472
business periormance ratios 296-7, 299 public relations 469, 472
business risk, credit rating assessment 380-1 companies 35-6
competitive characteristics 449
call option 342 competitor analysis 444-54
capacity 9-10. 112, 125 complex structures 489
consumer loans 147-8 compulsion 224-5
corporate loans 246 computers, role in lending process 24-8
personal loans 153 concentration risk 336
capacity to contract 207 conditions 12,48,113,127,246
capital 10, 246, 289 confidentiality of stored data 437
capital adequacy 371, 372-4 consent under privacy law 207-9
guidelines 382-4 consumer credit
capital costs 359 legal aspects 160-2
capitalisation approach 182 trends 162-6
cash 112, 125-6 consumer lender
cash break-even point 68-9 credit union, day in the life of 232-4
cash rate 270 day in the life of 158-60
cashflow budgets 299 consumer lending, technology effects 166
cashflow projections analysis 299-300 consumer loan application examples 152
cashflow statements 299 credit card loans 153-4
cashflows 243 personal loans 152-3
central management 273 consumer loan applications, credit scoring 155-8
character 6-9, 112, 125 consumer loan applications evaluation 146
consumer loans 146-7 capacity to repay 147-8
corporate loans 245-6 character 146-7
personal loans 152-3 collateral 148
character assessment 7-8 general principles 146-8
business borrowers 9 consumer loans 138-9
individual borrowers 8 legal framework 206-12
charge on assets 48 precautions in granting 154-5
chi-square automatic interaction detector pricing and structuring 166-9
(CHAID) 100-1 types of 139-46
clean remittance after the buyer receives or sells the see a/so personal loans; credit card loans; home
goods 323 loans
clean sale supply of assets 375-6 Consumer Transaction Act 1972 (SA) 212
Clearing HOLisesAutomated Payments System contingent liability 329
(CHAPS) 416 continuing guarantee 213
contract law 207 credit risk 109,129
contracts and consumers legislation 212 definition 109-10
Contracts Review Act 1980 (NSW) 212 of major Australian banks, case study 521-3
co-operatives 36 credit risk analysis 110-24
coordination problem 403-4 econometric analysis 110, 120-3
corporate failure, and credit ratios 80 expert systems 110-15
corporate lending 242 hybrid systems 110, 123-4
overview 242-3 issues 129-30
purpose 243-4 putting it all together 124-30
corporate lending principles 244-5 risk premium analysis 110, 115-19
lending cycle 247-50 credit risk analyst, day in the life of 364-5
methods of lending assessment 245-7 credit risk management 357-8
product structure and application 252-4 and securitisation 354-5
structuring the loan proposal 250-2 credit risk measurement 336-7
corporate market 445-6 Altman's Z score 337-41
cost approach 181-2 using stock prices 341-4
cost estimation 462-4 credit scoring 275
cost of funds 359 behavioural aspects 91-2
cost plus pricing 463 consumer loan applications 1558
country risk analysis 312 imperative for 92-4
and international credit evaluation 313-15 credit scoring approach 302-7
creative accounting techniques 74-5 background to small business lending in the United
credit analysis 5-6 States 302-3
modem approaches 17-18 changes and predictions 305-7
traditional methods 6-17 implications for Australia 307
credit approval models 96 past and present use in the United States 303-4
credit assessment 275 credit scoring models
credit card lending, trends 164-6 statistical decision-making methods 96-101
credit card loans 142-4 structure, United States 304
evaluation steps 151-2 credit scoring techniques 17, 89
example 153-4 implementation within the organisation 102-5
credit cards 31,417-18,421,458 overview 89-90
advantages for the credit card issuer 144-5 social and ethical issues 101-2
advantages to the customer 143 see also statistical credit scoring
benefits for merchants who accept 144 Credit Union's Dispute Resolution Centre 229
how they work 144-6 CreditMetrics™ 345, 348-52, 361
legal issues 224 cross-sectional techniques 49-60
credit costs 360-1 common-size statements 59-60
credit culture 4, 38 ratio analysis 49-59
credit default swaps 355-6 cumulative default probability 117
credit derivatives 355-7, 376-7, 487 current ratio 51-2,112,125
credit event 355 custom-developed transaction processing
credit markets 489-90 systems 422
loan sales 490-1 customer relationship management (CRM) 474-5
securitisation 490
transferable loan certificates 490 data integration 437
credit migration 110 dealer panels 484
credit options 355 debt covenants 37
credit rating agencies 254-5, 314, 378-9 debt-equity ratio 57-8, 112, 126
business risk 380 debtor, monetary obligations 210
financial risk 380-1 deception in financial statements 293
credit rationing 286 decision tree models 99
credit references about customers 224 default, causes of 390
1f"'J
1
,410"
default point 342, 343 legal and reputational risk management 437
a ,"',
default situations 399-400 regulatory and risk management issues 435-7
coordination problem 403-4 security controls 436-7
legal examples 406-7 trends in Australia 420-32
i' , mild financial distress 400-1 electronic cash 418, 434
1\ '"""
moderate financial distress 401 -2 electronic data interchange (EDI) 41 8
'l'
other breaches 405-6 financial 424-5
P"
t, severe financial distress 402-3 electronic payment systems 41 4,41 7-1 8
h delivery system strategy 464-8 electronic systems for lending 427-32
delivery systems, types of 465-8 encumbrances 178, 222
i
demographic factors 446 environmental characteristics 450
'II deregulation 92 environmental issues and lending institutions 238
direct entry transactions 41 7 equipment leasing 32
direct finance 480, 484 equitable mortgages 213
direct liability 329 equity participation 31
"
I
, direct loan 253 establishment fee 38
discounted cashflow techniques 63 ethical issues, in applying credit scoring
benefit-cost ratio 65 techniques 101 -2
internal rate of return 64-5 execution of documents 216
net present value 63-4 balance confirmation letters 217
discriminant analysis 122-3 forms and contents of loan documents 217
distance delivery systems 467 parties who execute the documents 21 6-1 7
distribution channels 443 signing of documents 217
documentary bill of exchange 31 9-20 stamp duty 217
docurnentary credits providing for term drawings 323 expected default frequency 1 23,341 -4
documentary export bills for collection 31 7-18 expected losses 360-1
documentary letters of credit 320-1 expert systems 101, 11 0-1 5
head and counter credits 322 five Cs analysis 11 1-1 4
red clause credits 321 PARSER 115
transferable docurnentary credits 322 export/import payment systems 31 6-25
uniform customs and practice 325 external conditions 12
durability (security) 11 external factors affecting lending decisions 19-20
duration nurnber 346
duress 224-5 factoring 32-3
dynamic provisioning 393, 398-9 Fair Trading Acts 21 2
Federal Reserve Communication System (Fed
e-cash 418, 434 Wire) 41 5
e-comrnerce, role of banks in 425-6 fee-based income 483
econornetric analysis 18, 110, 120 fee simple interest 1 77,222
discriminant analysis 122-3 fees and charges see bank fees
regression analysis 120-2 financial EDI 424-5
economic analysis 48 financial institution, marketing plan 444-75
economic factors, international lending 328 financial intermediation 480-1
efficiency ratios 53 bank lending 481-2
average collection period 55-6 lending function 482-3
inventory turnover ratio 53-5, 125-6 superannuation providers 484-5
EFTPOS 415, 418, 422, 433, 466 financial ratios 296-9
electronic banking 41 9-20 use by loan officers 78-83
board and management 435-6 financial risk, credit rating assessment 380-1
definition 41 4-1 5 financial statements 46-7
effects of 493 delays in preparation, small business 291 -2
evolution 41 5-1 7 importance of 256-7
futuristic view 438 why lenders analyse 47-9
financial statements analysis 46, 49-62 hereditaments 177
combining financial statement and nonfinancial historical financials analysis 295
statement information 61 -2 avoiding garbage in, garbage out 295-7
cross-sectional techniques 49-60 detailed analysis 297-9
detecting window dressing, frauds and errors 73-8 home banking 41 9-20, 467
limitations 83 home lending, trends 191
step-by-step approach 69-73 home loan applications 177-8
time series techniques 60-1 example 186-7
financial supermarket 466-7 financial appraisal 185-6
Financial Transactions Recording and Clearance step-by-step evaluation 183-4
System (FINTRACS) 419 valuation of property 179-83
first way out 288 home loans 176
five Cs analysis 6-1 7,21 ,1 1 0,1 1 1 -1 3 bank fees 195
corporate loans 245-6 calculation of interest on loans 193-4
example and solution 113-1 4 determinants on interest rates 194-5
usage 125-7 legal requirements specific to 220-3
fixed charges coverage ratio 59 loan pricing 192-5
fixed interest rate precautions in granting 188-9
consumer loans 167 terminology 177-8
home loans 193, 194 hurt money 244
small business loans 270-1 husband and wife (borrowers) 34
floating rate finance 269-70 hybrid systems 18, 110, 123
foreclosure 222-3 expected default frequency 123
foreign currency advance 328 mortality models 123-4
foreign currency trade finance facility 320
forfaiting 324-5 image processing 423
forged mortgage documents 189 impaired assets 391 -2
forms and contents of loan documents 217 import/export payment systems 31 6-25
framework for credit and lending decisions 18-1 9 indicator lending rates 37, 270
borrower-specific factors 20-1 indirect finance 480-1
external factors affecting lending decisions 19-20 individual borrowers, character assessment 8
lending institution-specific factors 20 industry analysis 48
franchising 143 industry-specific factors 19
freehold interest 177, 222 'informationally opaque' 286
full-service branches 465 insolvents 34, 207
fully automated branches 466 insurance companies 486
fully drawn advance 269 integrity 9
intelligent terminals 467
garbage in, garbage out (GIGO) 295-7 interbank exchange and settlement circuits 419
gays and lesbians, financial services for 226-7 interbank market 31 2,31 3
general law of the land 19 intercompany loan 253
general provisions 395-6 interest coverage ratio 58-9
genetic algorithms 100 interest in real estate 177,222
geographic cluster 445 interest rate risk 359-60
globalisation 491 interest rates on loans 215-16
glossary 524-31 consumer loans 167
good loans 90 home loans 193-5
gross profit-sales ratio 56 interest spread 483
guarantees 48,21 0,21 3-1 4 intermediation 252,253,31 2
internal conditions 12
hard information 287 internal rate of return 64-5
head and counter credits 322 internal ratings system for allocating credit 383
- I' -
international credit evaluation, and country risk lending principles 4, 5, 242
analysis 31 3-1 5 and credit analysis 5-1 8
international financial system 31 2-1 3 lending process
international lending 312 role of computers 24-8
overview 312 ten-step approach 21 -4
trade finance 31 5-25 lessee 177
uniform customs and practice for documentary lessor 177
credits 325 letter of credit 253
international lending principles 325-6 leverage ratios 57
bank guarantees 330-1 debt-equity ratio 57-8, 126
liabilities 329-30 fixed charges coverage ratio 59
profitability 329 interest coverage ratio 58-9
safety 326-7 liabilities 329-30
security 327-8 liens 178, 222
suitability 329 lifecycle of a loan 242, 247-50
Internet banking 414, 420, 427, 429, 434 limited-service branches 465-6
inventory turnover ratio 53-5, 112, 125-6 liquidation 393, 401, 402-3
investment home loans 176 liquidity 359
liquidity ratios 51
JOintaccounts 34 current ratio 51 -2,1 1 2,1 25
joint tenancy 177 quick ratio 52-3
judgemental credit scoring 98 literary societies 36
judgemental decision-making 91 loan administration fee 38
versus statistical credit scoring 94-6 loan agreement form setting out the terms and
conditions of the loan 215
.1
key person risk 289 general contractual considerations 215
repayment terms, interest and costs 21 5-1 6
lack of capital, small business 289-90 loan budget 20
large corporate entities, loan structuring 252 loan contract 207
large credit exposures 371, 374-5 loan documentation 212
larger national banks 288 assignment of shares or life policies 21 4-1 5
leasehold interest 177, 222 bill of sale 214
leasing 459 execution of documents 21 6-1 9
legacy systems 424 guarantees 21 3-1 4
legal and reputational risk management, electronic loan agreement form setting out the terms and
banking 437 conditions of the loan 21 5-1 6
legal aspects of consumer credit 160-2 mortgage deed 213
,1 legal framework for consumer and real estate promissory note 213
1,\
"I loans 206-1 2 loan documents under Uniform Consumer Credit
11 legal issues affecting overdrafts and credit cards Code 209-1 0
223-4 loan officer, skills required 255
legal requirements specific to home loans 220-3 loan originators 484
lenders' mortgage insurance (LMI) 10, 176, 196-8 loan portfolio 92, 243-4
current challenges in the housing market 198-200 designing 39
steering through the 'riskbergs' 200 management 257-63
lending assessment, corporate sector 245-7 advice from the past 261 -3
lending bankers, special rights 21 9-20 what can go wrong? 257-8
lending criteria 242 external factors 258-9
lending cycle, corporate loans 247-50 internal factors 259-61
lending function 482-3 loan pricing 358-65
lending institution-specific factors 20 balance sheet costs 359
i8ncJing officers, checklist 230-1 consumer loans 176
ienulng policy of the institution 20 credit costs 360-1
example 361-3 product development and marketing strategy
noncredit risk costs 359-60 457-60
practical 363 product pricing strategy 461-4
real estate loans 192-5 maturity 176
loan sales 490-1 media planning 471
loan structuring medium-term to long-term trade finance 323-4
consumer loans 168-9 mild financial distress 400-1
corporate loans 250-1 minors 33, 207
home loans 195-6 mobile branches 466
loan syndication 32 mobile commerce 430-1
loan-to-value ratio (LVR) 141 mobile phone banking 420, 430
loans 29 moderate financial distress 401-2
classified according to purpose 30 modern types of advance for businesses 31-3
classified according to region 30 equipment leasing 32
classified according to sector 30 equity participation 31
classified according to security 29 factoring 32-3
classified according to the term of the loan 29-30 loan syndication 32
moral hazard 286, 372
classified according to type of borrower 29
mortality models 100, 123-4
local authorities 36
mortgage 178
logistic regression 99
mortgage broker, day in the life of 184-5
logit analysis 122
mortgage deed 213, 221-2
longer term solvency ratios 296, 297-9
mortgage documents, forged 189
mortgage insurance see lenders' mortgage insurance
m-banking 430-1
mortgage market share, competition for 175-6
macroeconomic factors 19
mortgage originators 483-4
mail solicitation score 97
multiple regression 120-1
management information systems 96
margin call 141
negative pledges 37
margin lending 141, 458
net present value 63-4
margin of safety 48, 68
net profit-sales ratio 56-7,112,126
market analysis 444-5
neural networks 18, 99-100
screening the retail market 446-50
new instruments 486-7
screening the wholesale or corporate market
application of wholesale products to retail
445-6
customers 488-9
SWOT analysis 450-4
complex structures 489
market-based premiums 127 credit derivatives 487
market characteristics 448-9 securitisation 487-8
market penetration pricing 464 new lenders 483-4
market rate pricing 464 insurance companies 486
market segmentation 242, 445-6 nonbank institutions 485
market value approach 179-81 superannuation and other funds 484-5
marketability (security) 11 noninstalment loans 140-1
marketing nonbank institutions 485
role in financial institutions 443-4 noncredit risk costs 359-60
to achieve excellence 473-4 nonrepudiation 436
marketing coordinator, day in the life of 460-1
marketing plan (financial institution) 444 old (general law) system of title 221
analysis of retail banking needs 454-5 ombudsman 228
analysis of wholesale banking needs 455-7 online lending 427-32
communications strategy 468-72 online retail branches 422
delivery system strategy 464-8 operating costs 360
market analysis 444-54 optimisation models 18
option modelling 341 -3 pricing issues (advances) 37-8
Orbital Engine Corporation Ltd, case study 51 2-15 pricing strategy 463-4
originating costs 360 primary market 313
overdrafts 28, 30-1 , 140, 269 prime lending rate 270
legal issues 223-4 principles of lending 4, 5, 242
owner-occupied home loans 176 and credit analysis 5-1 8
owner's margin 10 Privacy Act 1988 162,207-9
probability 89
PARSER 115, 245, 246-7 probability modelling 97
parties who execute the documents 21 6-1 7 probit analysis 121
partnerships 35 problem loan management 390-407
pass through structures 353-4 causes of default 390
pay through structures 354 dealing with defaults 399-406
payback period 63 problem loans
personal borrowers 33-4 and business cycle 393-4
personal identification number (PIN) 418 dynamic provisioning 393, 398-9
personal lending, trends 163 extent of 391 -3
personal loan evaluation steps 148 other considerations 397-8
accepting and loading applications 149 provisions 394, 395-6
approving/rejecting applications 151 regulatory issues 394, 396-7
conducting a preliminary assessment 149 product development and marketing strategy 457-60
determining interest, fees and charges 150-1 product pricing strategy 461 -2
obtaining a prescribed application form 148-9 estimating cost structure 462-4
supervising the loan and following up 151 product structure and application, corporate
taking securities 150 loans 252-4
personal loans 140-2 profit and loss statement 46, 291
application example 152-3 profitability 5, 329
personal selling 469, 472 profitability ratios 56
persons of unsound mind 34 gross profit-sales ratio 56
political factors, international lending 328 net profit-sales ratio 56-7,1 26
poor quality of accounting information (small project evaluation methods 63
business) 291 accounting rate of return 63
deception 293 discounted cashflow techniques 63-5
delays in preparation of financial statements 291 -2 payback period 63
emphasis on taxation 292 project financing 253-4, 459
reporting freedoms for a small proprietary project risk analysis 65
company 292-3 break-even analysis 66-9
portability (security) 11 sensitivity analysis 66
portfolio management 344-5 simulation 69
Altman's Sharpe Index approach 347-8 promissory note 178,21 3
credit derivatives 355-7 promotion 469,472
CreditMetrics™ 348-52 property 177,220
risk-adjusted return on capital 345-7 property valuation 179-83
securitisation 352-5 provisions 394, 395-6
post-shipment finance facility 31 8-19 prudential regulation 371
practical loan pricing 363 public records 178
pre-payment 317 public relations 469, 472
pre-payment risk 360 put option 342
pre-shipment finance facility 318
pricing and structuring quantitative credit screening 96
consumer loans 166-9 quick ratio 52-3
real estate loans 191-201
priCing at value in use 463 ranking 89
rating agencies 254-5,31 4 1990s and today 422-5
rating systems 17 trends and issues 420-7
ratio analysis 49-59 retail market 445, 446-50
efficiency ratios 53-6 analysing market/industry characteristics 448-50
leverage ratios 57-9 analysing opportunities 448
liquidity ratios 51 -3 application of wholesale products to 488-9
profitability ratios 56-7 defining customer needs 448
real estate 177, 230-2 understanding customers 446-8
real estate credit, trends 190-1 retum on funds 329
real estate lending 458 revolving credit 253
real estate loan applications 177-8 revolving facilities 376
example 186-7 revolving line of credit 140
financial appraisal 185-6 revolving underwriting facilities 253
step-by-step evaluation of home loans 183-4 right to appropriate payments 220
valuation of property 179-83 right to set-off 220
real estate loans risk-adjusted retum on capital 345-7
documentation review worksheet 218-19 risk assessment, international lending 328
legal framework 206-1 2 risk-based capital ratio 372
precautions in granting 188-9 risk capital 176
pricing and structuring 191-201 risk premium 37
real-time gross settlement (RTGS) 419 risk premium analysis 110, 115-1 9
recourse 375 risk premiums over time 117-1 9
red clause credits 321
regional banks, and Basel II capital standards 383-4 safety buffer 48
regression analysis 99, 120-1 safety of loan 5
advanced 121 -2 international lending 326-7
regulation developments 377-84, 492-3 schools 36
Basel II 382-4 second way out 288
credit ratings 378-81 secured housing finance 176
regulator for credit risk 371 -84 securitisation 352-3, 487-8, 490
see a/so Australian Prudential Regulation Authority and credit risk management 354-5
regulatory issues, problem loans 394, 396-7 and large exposures 374
relational technology 423 clean sale supply of assets 375-6
relationship banking 272-3, 274, 288, 336 pass through structures 353-4
relationship management approach 294-302 pay through structures 354
analysis of cashflow projections 299-300 revolving facilities 376
analysis of historical financials 295-9 security 37, 271, 301
assessment of risks 301 economic/political factors 328
importance of security 301 financial standing of clients 327-8
problems with 301 -2 international lending 327-8
relationship manager 272-3 ongoing risk assessment 328
relationship pricing 464 security controls, electronic banking 436-7
repayment terms 215 segment see market segmentation
Reserve Bank Act 1959 19-20 segregation of duties 437
Reserve Bank Information and Transfer System sensitivity analysis 66
(RITS) 419 sensitivity testing 48
Reserve Bank of Australia 144-5, 190, 268, 269, service characteristics 449
271 ,272,371 ,462 set-off, right to 220
residentially secured loans 275-6 shared ATM networks 422
retail banking needs analysis 454-5 Sharpe Index 345,347-8
retail financial services technology in Australia short-term liquidity ratios 296, 297
1980-85 421 -2 signing of documents 217
1986-89 422 simulation 69
.+,
""t
. small and medium enterprises (SMEs) 93 statement of financial position 46
small business statistical credit scoring 89
" and bank fees 277-9 development 90-2
,
, "'t
' '
,
attitude to lenders 276-80
definition 267
imperative for 92-4
versus traditional judgemental methods 94-6
in the economy 268-9 statistical decision-making methods, used in credit
political importance 280-2 scoring models 96-101
sinall uusilless failure 293-4 statute of limitations 223
small business finance 269 step-by-step approach to financial statements analysis
bill finance 271-2 check for consistency 70
fixed rate loans 270-1 collect data about industry and general economic
floating rate loans 269-70 trends 71 -2
small business lender, day in the life of 282-5 conduct a comparison with industry averages 72
small business lending 267 do supplementary analysis 72
characteristics 269-72 obtain relevant financial statements 69-70
credit scoring approach 302-7 summarise the main features 72-3
;'
how lenders organise 272-5 undertake preliminary scrutiny 70-1
market competition 275-6 step-down approach 315
overview 267-9 stock prices, for credit risk measurement 341 -4
political Importance 280-2 stored-value cards 414, 418
relationship management approach 294-302 stress testing 48
theoretical basis for understanding 285-8 structuring of advances 37-8
small bUSiness lending decision 288 37
specialised risks 288-9 pricing issues 37-8
key person risk 289 security 37
lack of capital 289-90 structuring of consumer loans 168-9
lack of track record 290-1 suitability of loan purpose 5, 329
poor quality of accounting information 291 -3 summation approach 181
r!3KSC111d small business failure 293-4 superannuation providers 484-5
small business loans, cut-off point 273-4, 275 SWIFT Payment Delivery System (PDS) 419
small corporate entities, loan structuring 251 SWOT analysis 450-4
small proprietary companies 292-3 syndicated facilities 253
Silldilbi cormnullity banks 288
smart cards 414 target pricing 463
social Issues, in applying credit scoring taxation 292
techniques 101-2 technology 89, 92
Society for Worldwide Interbank Funds Transfer impact on consumer lending 166
(SWIFT) 416 to handle front-office branch operation 421
soft information 287 see also retail financial services technology in
soft spots 296 Australia
sole proprietorship 35 technology-driven innovation in Australia's financial
special rights of lending bankers 21 9-20 services sector 432-5
special types of borrowers 36 telemarketing 467
specialised branches 466 tenancy in common 1 77,222
specific guarantee 213 term structure of interest rates 115
specific provisions 395 theory of small business finance 285-8
spendth rift 9 tier 1 capital 372, 373
staff availability (to appraise loans) 20 tier 2 capital 372, 373
stamp duty 217 time series analysis 47
Standard & Poor's credit ratings 378-9, 380, 381 time series techniques 60
standby lines 253 trend of financial ratios 61
trend statements 60
statement of financial performance 46, 80-1 variability measures 61
title 220-1 Uniform Consumer Credit Code 20,21,160,209
title deeds 178 fees and charges 210
Torrens mortgages 213 loan documents under the code 209-10
Torrens system 221 monetary obligations of the debtor 210
total retum swaps 355,356 other important clauses 210
track record 290-1 penalties for noncompliance 210-11
trade finance 312,315-16 Uniform Customs and Practice for Documentary
bankers' acceptance market 324 Credits 325
clean remittance after the buyer receives or sells the unincorporated associations 36
goods 323 United States
documentary bill of exchange 319-20 credit scoring models structure 304-5
documentary credits providing for term past and present use of credit scoring 303-4
drawings 323 small business lending 302-3
documentary export bills for collection 317-18 unused limit fee 38
documentary letters of credit 320-2
foreign currency trade finance facility 320 valid purpose for loan 5
forfaiting 324-5 valuation of property 179-83
medium-term to long-term 323-4
capitalisation approach 182
methods of payment and financing
cost approach 181-2
techniques 316-17
market value approach 179-81
post-shipment finance facility 318-19
value added networks (VANs) 418
pre-payment 317
variability measures 61
pre-shipment finance facility 318
variable interest rate
Trade Practices Act 1974 161, 211
consumer loans 167
traditional methods of credit analysis 6-17
home loans 193, 194
credit scoring systems 17
Veterinary Clinic Pty Ltd, case study 516-20
five Cs of lending 6-17
rating systems 17
Wallis Report 419, 446, 447, 448, 462, 466, 467
traditional types of advance 29
wholesale banking 423
loans 29-30
wholesale banking needs analysis 455-7
overdrafts 30-1
transaction processing systems technology 421 wholesale market 445-6
transferable documentary credits 322 wholesale products, application to retail
transferable loan certificates 490 customers 488-9
trend analysis 47 window dressing, detecting 73-6
trend of financial ratios 61 wireless application protocol (WAP) 420
trend statements 60 working capital 257
truncation 423
yield curve 271
undue influence 224
unexpected losses 361 zone of ignorance 340

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Textbook PTTDCV

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First published 2003 by

John Wiley IS!:Sons Australia, Ltd

Typeset in 11/13 Berkeley

© Milind Satlwc, James Bartle, Michael Vincent,

National Library of Australia

Credit analysis and lending management.

1. Credit. 2. Credit - Management. 3. Loans.

All rights reserved. No part of this publication

Illustrated by the Wiley Art Department

Cover image © 2002 Digital Vision/Sara Hayward

Every effort has been made to trace the ownership of

This book is dedicated to the memory of Milind Sathye's mother,

has been very aggressive and is picking up

indicate that the nonbanks have yet to make sig-

- Variable - Three·year fixed

Smallllll Medium. Large.

FIGURE 1.1 A framework for credit and lending decisions

FIGURE 1.2 National Australia Bank's checklist for business borrowers

hllying a pr<)found impact on how banks per-

How dOes credit risk?

What can go wrong?

the benefit of hindsight we

Source: Zeta Services Pty Ltd.

How a credit scoring system can be nsed

We have explained the principles of lending, the framework for making

The above aspects of structuring advances are important at the operational

I 46 Part2: Analysisandinterpretationof creditrisk I

I 48 Part2: Analysisandinterpretationof creditrisk I

Net sales 70.1 62.3

City First Saddlery Limited

LiabilitiesandEquity 2003 2002 Assets 2003 2002

Share capital 15 15 Net fixed assets 33 32.20

50 Part2: Analysisand interpretationof creditrisk

52 Part2: Analysisandinterpretationof creditrisk I

Benchmark and interpretation

The inventory turnover ratio

I 54 Part2: Analysisandinterpretationof creditrisk I

The average collection period

(The figure of 9.76 for 2002 has been assumed.)

I 56 Part2: Analysisandinterpretationof creditrisk I

= 0.047, or 4.7% = 0.067, or 6.7%.

Earnings before interest and taxes

I 58 Part2: Analysisandinterpretationof creditrisk I

Accounts receivable 7.6 9.8 3.2 5.4

Inventories 20.5 23.7 35.2 48.1

Accounts payable 15.9 5.6 6.7 19.2

Equity 36.2 21.5 65.4 49.2

1999 2000 2001 2002 2003

Sales revenue 56.7 58.4 60.2 62.3 70.1

Indexed sales revenue 100.00 103.00 106.17 109.52 123.98

60 Pari2: Analysis and interpretation of credit risk

1999 2000 2001 2002 2003

Current ratio 1.12 1.19 1.28 1.47 1.34

Debt-assets ratio 0.52 0.61 0.59 0.93 0.55

Inventory turnover ratio 5.52 5.78 6.15 6.83 6.61

Average collection period (days) 55 59 65 56 61

Maximum value - Minimum value

62 Part2: Analysisandinterpretationof creditrisk

TABLE 2.4 Calculation of the net present value

1 500 0.909 454.50

2 750 0.826 619.50

3 1000 0.751 751.00

4 1250 0.683 853.75

5 1500 0.620 930.00