(Chapter-6) TECHNIQUES OF ALM: $ GAP AND DURATION GAP

❖ ALM
✓ ALM is generally viewed as short run in nature.
✓ ALM focuses on the day-to-day and week-to-week balance sheet
management .
✓ The best way to understand the role of ALM is to view it within the context
of the overall sources and uses of funds.
✓ The principal purpose of ALM traditionally has been to control the size of
the Nil.
✓ This control can be achieved through,
o Defensive
o or aggressive management.
✓ The process of making such decisions about the composition of assets and
liabilities and the risk assessment.
✓ Bankers make these decisions every day about buying and selling securities,
about whether to make loans and how to fund their investment and lending
activities.

✓ These decisions are based upon,

(1) their outlook for interest rates,
(2) the composition of their assets and liabilities, and
(3) the degree of risk that they are willing to take.
✓ The principal purpose has been to control the size of the net interest income.

The goal of defensive ALM

• The goal of defensive ALM is to insulate the net interest income from changes
in interest rates;
- that is, to prevent interest rate changes from decreasing or increasing the
net interest income.
• Defensive strategy attempts to reduce the volatility of net interest income.
The goal of aggressive ALM
• In contrast, aggressive ALM focuses on increasing the net interest income
through altering the portfolio of the institution.
• The success of aggressive ALM depends on the ability to forecast future
interest rate changes.
 • An aggressive strategy seeks to raise the level of net interest income.

✓ Both defensive and aggressive ALM relate to:

✓ the management of the interest-sensitivity position of the asset and
✓ liability portfolio of a financial institution, and
✓ the success or failure of both strategies depends on the effect of interest rates.
______***________
❖ INSTRUMENTS USED IN ALM
Banks generally use money market instruments to adjust their asset and liability
portfolios.
They include:
• federal funds
• short-term Treasury securities,
• federal agency securities,
• Euro-dollar time deposits
• and certificates of deposit (CDs),
• domestic CDs, and
• repos.
1.Federal Funds:Federal funds are short-term loans that banks extend to each
other overnight to meet reserve requirements.
• These funds are traded in the federal funds market and play a crucial role in
the interbank lending system.
2.Short-term Treasury Securities:These are short-term debt securities issued by
the U.S. Department of the Treasury.
• They include Treasury bills (T-bills) with maturities of one year or less.
• Banks often invest in T-bills as a low-risk, liquid investment option.
3.Federal Agency Securities: These are debt securities issued by government-
sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac.
• These securities are considered relatively safe and have varying maturities,
allowing banks to manage their asset and liability durations.
4.Euro-dollar Time Deposits: Euro-dollar time deposits are U.S. dollar-
denominated deposits held in banks outside of the United States.
 • These deposits provide flexibility in managing liquidity and interest rate risk
by allowing banks to access foreign markets.

5.Certificates of Deposit (CDs): CDs are time deposits offered by banks to

customers with fixed maturities and fixed interest rates.
• Banks can issue CDs to attract funds from depositors and manage their
liability structure effectively.
6.Domestic CDs: These are similar to Euro-dollar time deposits but are issued
domestically.
• Domestic CDs offer a convenient way for banks to raise funds and
-adjust their liability structure based on market conditions.
7.Repurchase Agreements (Repos): Repos are short-term agreements where a
bank sells securities to another party and agrees to repurchase them at a specified
price and date.
• Repos allow banks to borrow funds against collateralized securities,
- providing a means to manage short-term liquidity needs.
___________end______-
❖ Appropriate Degree of Interest Rate Risk:
✓ One of the most difficult decisions that bank managers face is determining the
appropriate degree of interest rate risk to assume.
✓ At one extreme, the bank would attempt to structure its assets and liabilities to
eliminate interest rate risk.
✓ The other extreme would bet the bank on expectations of interest rate changes.
✓ Few banks follow extreme, with most banks taking some but very limited
interest rate risk.
✓ The profitability of a bank that does not take some interest rate risk' might be
inadequate.
✓ A policy of eliminating all interest rate risk on the balance sheet may be
incompatible with the desires of the bank's loan customers.
✓ The expertise and risk preference of management is also significant.
_________end______
 ❖ DOLLAR GAP Management
The dollar gap (also referred to as the funding gap or the maturity gap), is the
difference between the dollar amount of interest rate-sensitive assets and the dollar
amount of interest rate-sensitive liabilities.
• Aggressive Management
✓ Predict the direction of future interest rates
✓ Adjust the RSAs and RSLs in order to take advantage of the projected
interest rates changes
o Defensive Management
• A defensive strategy attempts to keep the volume of the RSAs in balance with
the volume of RSLs over a given period.
• A defensive strategy is not necessarily a passive one.
Many adjustments in the asset and liability portfolio under a defensive strategy
are often necessary in order to maintain a zero-gap position.
____________end___________

❖ Complications of Dollar Gap Analysis

Deficiencies:
• The selection of time horizon:
➢ Dollar gap analysis involves choosing a specific time horizon over which the
interest rate risk exposure is evaluated.
➢ However, determining the appropriate time horizon can be challenging.
➢ If the time horizon is too short, it may not capture longer-term interest rate risks
and potential fluctuations.
➢ On the other hand, if the time horizon is too long, it introduces uncertainty and
relies on assumptions about future interest rate movements that may be less
reliable.
➢ Finding the right balance between accuracy and practicality is crucial.
• Repricing of assets and liabilities within the time horizon.
➢ Dollar gap analysis assumes that assets and liabilities will reprice, or adjust their
interest rates, within the selected time horizon.
➢ This assumption allows for estimating the impact of interest rate changes on
cash flows.
➢ However, in practice, not all assets and liabilities reprice simultaneously or at
the same frequency.
•Assumptions and Limitations:
➢ Dollar gap analysis relies on certain assumptions, such as the stability of interest
rates and the relationship between interest rate changes and asset and liability
cash flows.
➢ These assumptions may not always hold true in practice, leading to inaccurate
results.
➢ The assumption that the correlation coefficient co-efficient between the
movement in general market interest rates and the interest revenue and cost of
the portfolio of financial institutions is one.
➢ The solution to this problem is to use a standardized gap
• The focus of traditional gap management is on net interest income rather than
shareholder wealth.
• Non-Maturity Deposits:
➢ Dollar gap analysis may struggle to accurately capture the interest rate risk
associated with non-maturity deposits, such as demand deposits and savings
accounts.
➢ These deposits typically have variable interest rates and uncertain maturity
dates, making it difficult to determine their sensitivity to interest rate changes.

• Market Value Risk:

o Dollar gap analysis focuses primarily on the cash flow risk associated with
interest rate changes and
- may not adequately capture the market value risk of certain assets and
liabilities.
o Market value risk refers to the potential impact of interest rate changes on the
market value of securities and investments.

• Integration with Other Risks:

➢ Dollar gap analysis primarily addresses interest rate risk, but it does not
consider other risks such as credit risk, liquidity risk, or foreign exchange risk.
➢ To have a comprehensive understanding of the institution's risk profile, it is
necessary to integrate dollar gap analysis with other risk management
techniques.
________________end________
❖ Duration Gap Analysis
✓ Duration is a widely accepted measure of a financial instrument's interest rate
risk.
✓ In its most basic form, Macaulay duration, it is a measure of the effective
maturity of an instrument.
✓ More specifically, duration is the weighted average maturity of an instrument's
cash flows.
✓ The following equation is used to calculate Macaulay duration:
• Focuses directly on the MV of the institution
• Duration gap is measured "by taking the difference between the duration" of
asset portfolio and the duration of liability portfolio.
✓ It is a measure of interest rate sensitivity that helps to explain how changes in
interest rates affect the market value of a bank’s assets and liabilities, and, in
turn, its net worth.

___________end_____
 ❖ Problems with Duration Gap Management
• The shift of yield curve may not be parallel.
• Large DGAP may make sensitivity analysis meaningless
• Duration drift
Non-Parallel Shifts of Yield Curve:
✓ Duration gap analysis assumes that the yield curve shifts in a parallel manner,
meaning that interest rates across all maturities change by the same magnitude.
✓ In reality, yield curves can exhibit non-parallel shifts, with short-term and long-
term interest rates moving differently.
✓ This can lead to inaccuracies in duration gap analysis and may result in
suboptimal risk management decisions.

Large Duration Gap and Meaningless Sensitivity Analysis:

✓ If a financial institution has a large duration gap (the difference between the
durations of assets and liabilities), it may make sensitivity analysis less
meaningful.
✓ Sensitivity analysis aims to measure the impact of interest rate changes on the
institution's net worth or economic value.
✓ However, when the duration gap is significant, small changes in interest rates
can lead to significant fluctuations in the net worth, making sensitivity analysis
less reliable.

Duration Drift:
✓ Duration measures the sensitivity of the price of a fixed-income security to
changes in interest rates.
✓ However, duration is not a constant value and can change over time, a
phenomenon known as duration drift.
✓ Factors such as cash flows, prepayments, and changes in the yield curve can
cause the duration of assets and liabilities to change.
✓ Duration drift can make it challenging to maintain an accurate duration gap and
may require frequent adjustments to the portfolio to align with the desired risk
management objectives.

To mitigate these problems, financial institutions can take the following steps:
Consider Non-Parallel Shifts:
✓ Instead of relying solely on parallel shift assumptions, financial institutions
should incorporate more realistic scenarios that consider non-parallel shifts in
the yield curve.
✓ This can be achieved through scenario analysis, stress testing, or using more
advanced ALM models.
Use Additional Risk Measures:
✓ Instead of relying solely on duration gap analysis, financial institutions can
complement it with other risk measures such as convexity, value-at-risk (VaR),
or dynamic simulations.
✓ These measures provide a more comprehensive view of interest rate risk by
capturing the non-linear relationships between changes in interest rates and
asset and liability values.
Regularly Monitor and Adjust Portfolios:
✓ Financial institutions should regularly monitor their portfolios and make
necessary adjustments to account for duration drift.
✓ This involves ongoing analysis and recalibration of asset and liability durations
based on actual market conditions and changes in the institution's risk profile.
___________end___________

❖ ALM and Business/Interest Rate Cycle

Here's a breakdown of how the interest rate structure typically behaves
during different stages of the business cycle:
Expansion (Rising):
✓ During the expansion phase of the business cycle, the economy is growing, and
economic indicators are generally positive.
✓ In this stage, interest rates tend to rise moderately as demand for credit
increases.
✓ Lenders anticipate higher economic activity and adjust interest rates upward to
reflect the increased demand and potential inflationary pressures.
Peak (High):
✓ The peak represents the highest point of economic growth in the business cycle.
✓ At this stage, interest rates are typically high.
✓ Central banks may raise benchmark interest rates to control inflationary
pressures and prevent the economy from overheating.
✓ High interest rates can discourage borrowing and investment, which can help
slow down the pace of economic expansion.

Contraction (Falling):
✓ During the contraction phase, economic growth slows down or becomes
negative.
✓ Interest rates in this stage tend to fall slightly as the central bank tries to
stimulate economic activity by lowering benchmark interest rates.
✓ The reduction in interest rates aims to encourage borrowing and investment to
revive economic growth.

Trough (Low):
✓ The trough represents the lowest point of economic activity in the business
cycle.
✓ Interest rates during this stage are generally low.
✓ Central banks may keep interest rates at historically low levels to support
economic recovery and stimulate borrowing and investment.
✓ Low interest rates incentivize businesses and individuals to borrow and spend,
thus boosting economic activity.
 ___________end_________

❖ Interest Rate Risk Management and the Yield Curve

✓ The yield curve is a graphical representation of interest rates for various
maturities of fixed-income securities, typically government bonds.
✓ It shows the relationship between the interest rate (or yield) and the time to
maturity of these securities.
✓ By analysing the shape and movements of the yield curve, financial
institutions can gain insights into the current and future interest rate
environment and make informed decisions regarding their interest rate risk
exposure.
✓ Here's an explanation of how the yield curve is used in interest rate risk
management, along with a simplified graph.

▪ Yield Curve Shapes:

The yield curve can take different shapes, including upward-sloping (normal),
downward-sloping (inverted), and flat.
Each shape implies certain expectations and implications for interest rates.
Upward-sloping:

✓ In a normal yield curve, longer-term interest rates are higher than shorter-
term rates.
✓ This indicates expectations of economic expansion and inflation.
✓ Financial institutions may need to manage their interest rate risk by carefully
matching the durations of their assets and liabilities or using hedging
strategies.
Downward-sloping:

✓ In an inverted yield curve, shorter-term interest rates are higher than longer-
term rates.
✓ This shape often signals expectations of economic contraction or recession.
✓ Financial institutions may need to be cautious as an inverted yield curve can
indicate potential credit tightening and a higher risk of default.
Flat:

✓ A flat yield curve occurs when there is little difference between short-term and
long-term interest rates.
✓ This shape suggests uncertainty about future economic conditions.
✓ Financial institutions may need to closely monitor market developments and be
prepared for potential interest rate changes.
 ▪ Managing Interest Rate Risk:
Financial institutions use the yield curve to assess their interest rate risk exposure
and develop risk management strategies, including:
Asset-Liability Management (ALM):
✓ By comparing the durations of their assets and liabilities with the yield curve,
institutions can identify potential mismatches and adjust their portfolio
accordingly.
✓ They may increase or decrease the durations of their assets and liabilities to
align with their risk tolerance and market expectations.
Yield Curve Strategies:
✓ Financial institutions can employ yield curve strategies, such as yield curve
positioning or yield curve steepening/flattening trades, to capitalize on
anticipated changes in the shape of the yield curve.
✓ These strategies involve taking positions in bonds or derivatives to benefit
from shifts in yield curve levels or slopes.

Scenario Analysis:
✓ Financial institutions can conduct scenario analysis using different yield curve
scenarios to assess the impact of potential interest rate changes on their
portfolio.
✓ This helps them identify vulnerabilities and develop risk mitigation measures.
________end___________
❖ Simulation in ALM:
➢ Simulation is a powerful tool used in ALM to model and analyze the potential
outcomes of different scenarios and assess the impact of various risk factors on
the institution's financial position.
➢ Through simulation, financial institutions can simulate the behavior of assets,
liabilities, and market conditions over time to understand how their balance
sheet and financial performance may evolve.
➢ Here's how simulation is applied in ALM:
Cash Flow Modeling:
• Financial institutions use simulation techniques to model the cash flows of
their assets and liabilities based on various assumptions and scenarios.
• This helps them understand the timing and magnitude of future cash flows,
including:
o interest income,
o principal repayments,
o loan prepayments,
o deposit withdrawals,
o and other contractual obligations.

Interest Rate Risk Assessment:

• Simulation allows financial institutions to assess the impact of interest rate
changes on their balance sheet.
• By simulating different interest rate scenarios, institutions can evaluate the
potential effect on net interest income, net worth, and other risk metrics.
• This helps them identify potential vulnerabilities and develop strategies to
mitigate interest rate risk.
Liquidity Risk Management:
• Simulation helps financial institutions assess and manage liquidity risk by
modeling different cash flow scenarios and estimating the availability of
funds to meet obligations.
• It allows institutions to identify potential liquidity shortfalls, determine the
adequacy of liquid assets, and develop contingency plans to address liquidity
needs under various stress conditions.
Stress Testing:
• Simulation is crucial in stress testing, where financial institutions subject
their balance sheet and risk profile to extreme scenarios to evaluate resilience
and identify potential weaknesses.
• By simulating adverse market conditions, economic downturns, or specific
events, institutions can quantify the potential impact on their capital,
profitability, and solvency.
Scenario Analysis:
• Financial institutions use simulation to perform scenario analysis,
 -where they model different economic and market scenarios to understand how
changes in variables such as interest rates, inflation, credit quality, or market
volatility may affect their balance sheet and risk profile.
• This analysis helps institutions make informed decisions, set risk appetite, and
develop appropriate risk management strategies.
_____________END__________
(Chapter 7)An Introduction to Commercial Lending
Lending in a competitive environment
1. Banks are no longer unique
- Businesses raise funds from money and capital markets
- Borrow from other financial institutions
2. Reducing Risk (Credit "risk)
–Avoid making very high-risk loans
- Evaluate the creditworthiness of borrowers, obtain collateral, and obtain
guarantees
- Transfer credit risk to other parties by selling standardized loans
- Diversify loan portfolio.
➢ In a competitive lending environment, banks no longer have a monopoly on
providing loans as businesses have access to multiple funding sources,
including money and capital markets.
➢ To thrive in this environment, banks employ various strategies to reduce risk
and enhance their lending operations.
➢ Here's an explanation of the mentioned points:

1.Banks are no longer unique:

➢ In the past, banks held a dominant position in lending, but now businesses can
raise funds from money and capital markets.
➢ These markets provide alternative sources of financing such as issuing bonds,
commercial paper, or equity offerings.
➢ This shift means that banks face competition from other financial institutions
and market participants, requiring them to adapt their lending strategies to
remain competitive.
 • Borrowing from other financial institutions:
➢ To expand their lending capacity, banks can borrow funds from other financial
institutions.
➢ This allows them to meet the borrowing needs of customers without relying
solely on customer deposits.
➢ By borrowing from other institutions, banks can access additional capital to
support their lending activities and cater to a larger customer base.
• Businesses raise funds from money and capital markets.
2.Reducing Credit Risk:
➢ Credit risk refers to the potential loss arising from a borrower's inability to repay
a loan.
➢ Banks employ several strategies to mitigate this risk:

• Avoiding very high-risk loans:

➢ Banks establish risk thresholds and avoid granting loans to borrowers with
excessively high-risk profiles.
➢ This helps reduce the likelihood of default and potential losses.
• Evaluating creditworthiness:
➢ Banks thoroughly assess the creditworthiness of borrowers before extending
loans.
➢ This involves analyzing factors such as:
-financial statements,
-credit history,
-and cash flow capabilities to determine the borrower's ability to repay the
loan.
• Obtaining collateral and guarantees:
➢ Banks may require borrowers to provide collateral (such as assets or
property) or obtain guarantees from third parties to secure the loan.
➢ Collateral and guarantees serve as additional sources of repayment in case
the borrower defaults, reducing the credit risk for the bank.

• Transfer of credit risk through selling standardized loans:

➢ Banks can transfer credit risk to other parties by selling standardized loans.
➢ This can be achieved through securitization, where banks bundle loans
together and sell them as asset-backed securities to investors.
 ➢ By doing so, banks remove the loans from their balance sheets and transfer the
credit risk to investors.
➢ This helps banks reduce their exposure to credit risk and free up capital for
further lending activities.
Diversifying loan portfolio:
➢ Diversification of the loan portfolio is an effective risk management strategy.
Banks aim to diversify their loan portfolio across different loan types, sectors,
and borrower profiles.
➢ By offering a variety of loan products and serving diverse customer segments,
banks spread their risk.
➢ If one sector or loan segment faces economic challenges, the losses can be offset
by gains in other areas of the portfolio, resulting in a more stable lending
business.
___________end___________

❖ Types of Commercial and Industrial Loans

1.Line of credit
✓ A line of credit is a type of loan that provides businesses with access to a
predetermined amount of funds, which they can borrow as needed within a
specified period.
- Maturity: One year or less
- Purpose: finance seasonal increases in inventory and accounts
receivable
2. Collateral: inventory or accounts receivable
✓ Collateral is an asset that a borrower pledges to secure a loan.
✓ In the case of a line of credit, the collateral can be either inventory or accounts
receivable.
✓ This collateral provides a form of security to the lender in case the borrower is
unable to repay the loan.
3. Revolving
✓ A revolving line of credit allows businesses to borrow, repay, and borrow again
within the predetermined credit limit.
✓ As long as the borrower continues to make payments and remains within the
credit limit, they can access the funds multiple times without needing to reapply
for the loan.
4.Term loans
✓ Term loans have a specified maturity date and are repaid over a fixed period,
often with regular monthly installments.
✓ These loans are typically used for long-term investments, such as purchasing
equipment, expanding operations, or financing business acquisitions.
✓ The term and interest rate are agreed upon at the time of borrowing.
5. Bridge loans
✓ Bridge loans are short-term loans used to provide interim financing until a
more permanent financing solution is obtained.
✓ They bridge the gap between immediate financial needs and the availability of
long-term financing.
✓ Bridge loans are commonly used in real estate transactions or during business
acquisitions.
6. Overdrafts
✓ An overdraft occurs when a business withdraws more money from its bank
account than it has available.
✓ Banks may offer overdraft facilities to businesses, allowing them to
temporarily exceed their account balance.
✓ Overdrafts are typically charged with interest and fees on the overdrawn
amount.
7.Loan commitments
✓ Loan commitments are formal agreements between a lender and a borrower to
provide a specific amount of financing for a defined period.
✓ The borrower has the right to draw funds from the committed amount within
the specified timeframe.
✓ Loan commitments provide businesses with certainty regarding the availability
of funds when needed.
- Examples:
. - Asset sale and repurchase agreements
- Overnight forward purchase
- An irrevocable revolving line of credit
- Commitment fee
- Risk: Funding or liquidity risk
8.Leasing
✓ Leasing is a financing arrangement where a business rents equipment or assets
from a lessor for a specific period.
✓ There are different types of leasing arrangements:
. - Operating
- Financial
- Leveraged

• Operating Leases:
✓ Operating leases are short-term leases where the lessor retains ownership of the
asset.
✓ They are commonly used for equipment leasing and allow businesses to use the
asset without the long-term commitment of ownership.
• Financial Leases:
✓ Financial leases are long-term leases where the lessee gains substantially all the
benefits and risks associated with owning the asset.
✓ The lessee usually has the option to purchase the asset at the end of the lease
term.
• Leveraged Leases:
✓ Leveraged leases involve a partnership between the lessee, lessor, and lender.
✓ The lender provides a portion of the funds needed to acquire the asset, and the
lessee makes regular lease payments to the lessor.
_____________end_________
❖ Collateral
✓ Collateral is an asset or property that a borrower pledges to secure a loan.
✓ It provides a form of security to the lender, as it can be seized and sold to recover
the outstanding loan amount in case the borrower defaults on repayment.
- Characteristics:
I. Standardization
II. Durability
III. Marketability.
 IV. Stability of value
Standardization:
✓ Collateral should have standardized attributes that make it easily identifiable
and quantifiable.
✓ This allows lenders to determine its value accurately and assess its suitability as
security for the loan.

Durability:
✓ Collateral should be durable and able to withstand the passage of time without
significant deterioration.
✓ This ensures that its value remains relatively stable over the loan term,
providing confidence to the lender that it can be sold to recover the loan amount
if necessary.

Marketability:
✓ Collateral should have a ready market where it can be sold quickly and easily.
✓ It should possess characteristics that make it attractive to potential buyers,
ensuring that it can be converted into cash without significant delays or
complications.

Stability of Value:
✓ Collateral should exhibit stability in its value or have the potential for
appreciation over time.
✓ This helps mitigate the risk of a decline in value, ensuring that the collateral
maintains its worth as security for the loan.
- Types:
- Accounts receivable
-Inventory
1. Accounts Receivable:
✓ Accounts receivable refers to the money owed to a business by its customers for
goods sold or services rendered on credit.
✓ These outstanding invoices can be pledged as collateral.
✓ Lenders may evaluate the creditworthiness of the customers and the quality of
the accounts receivable before accepting them as collateral.
2. Inventory:
✓ Inventory includes the stock of goods or raw materials held by a business for
sale or production.
✓ It can serve as collateral, especially in industries where inventory can be easily
valued, such as retail or manufacturing.
✓ The value of inventory as collateral may vary based on factors like market
demand, perishability, and obsolescence risk.
________end____________
❖ Floating lien
• Trust receipts or floor planning
• Warehouse receipts
-Terminal warehouse
-Field warehouse
• Marketable securities
• Natural Resources
- Oil and gas reserves
• Real property and equipment
• Guarantees
Floating Lien:
✓ A floating lien is a type of collateral that grants the lender a security interest in
a borrower's assets that may change in quantity or type over time.
✓ It provides flexibility to the borrower to use and replace collateral assets without
requiring the lender's approval for each transaction.
✓ This type of lien is often used in revolving credit facilities or lines of credit
where the collateral may vary, such as accounts receivable or inventory.
➢ Trust Receipts or Floor Planning:
• Trust receipts or floor planning involve financing arrangements in which a
lender provides funds to a borrower to purchase inventory or equipment.
• The lender retains a security interest in the purchased items until the borrower
repays the loan.
• Once the borrower sells the inventory or equipment, they are required to repay
the lender using the proceeds.
➢ Warehouse Receipts:
• Warehouse receipts are documents issued by a warehouse operator or storage
facility to acknowledge the receipt and ownership of specific goods or
commodities.
• These receipts serve as collateral for loans, allowing borrowers to pledge the
stored goods as security.
• The lender holds the receipts until the loan is repaid, and the borrower can
reclaim the goods by presenting the receipts.
• Terminal Warehouse:
-A terminal warehouse is a storage facility where goods are temporarily held before
being transported to their final destination.
-Terminal warehouse receipts can be used as collateral for loans, with the lender
holding the receipts until the loan is repaid.
• Field Warehouse:
-A field warehouse is a storage facility located closer to the point of production. -
Similar to terminal warehouses, field warehouse receipts can serve as collateral for
loans by providing security based on the value of stored goods.
-The lender retains the receipts until the loan is repaid.
➢ Marketable Securities:
• Marketable securities, such as stocks, bonds, or other tradable financial
instruments, can be pledged as collateral for loans.
• These securities are easily marketable, providing a reliable means for lenders to
recover their investment in case of default.
➢ Natural Resources:
• Certain collateral can include natural resources such as timber, minerals, or
water rights.
• The value of these resources is evaluated, and lenders may secure loans
against the expected income or the underlying value of the natural resources.
• Oil and Gas Reserves:
-In the energy sector, oil and gas reserves can be used as collateral for loans.
-The value of the reserves, estimated based on geological data and production
potential, serves as security for the loan.
➢ Real Property and Equipment:
• Real property, such as land, buildings, or other immovable assets, can be
pledged as collateral for loans.
• Additionally, equipment owned by a business can also be used as collateral to
secure financing.
➢ Guarantees:
• Guarantees are promises made by a third party to assume responsibility for the
repayment of a loan if the borrower defaults.
• While not a traditional form of collateral, guarantees provide an additional layer
of security for lenders.
_____________end_______
❖ The Lending Portfolio Decision
_The amount of bank capital
- The size of the loan
- The size of the bank
- Economic condition
_The lending policies of the bank
_Bank size and scope of services
- Participations
_Interest rates and credit risk
_ending and funding strategies
Written Loan Policy
- General policy
- Risk
. - Loan supervision
- Geographic limits
- Credit policies.
The lending portfolio decision involves various factors and considerations that
banks take into account when managing their loan portfolios. Here's an explanation
of the key elements mentioned:
1.The Amount of Bank Capital:
✓ The amount of capital a bank has available influences its lending decisions.
 ✓ Banks need to maintain adequate capital levels to absorb potential losses on
loans.
✓ Capital serves as a cushion against unexpected credit losses, providing
stability and confidence to depositors and regulators.

2.The Size of the Loan:

✓ The size of the loan is an important factor in the lending portfolio decision.
✓ Banks consider the borrower's creditworthiness, repayment capacity, and the
purpose of the loan when determining the loan size.
✓ Larger loans may carry higher risks, requiring more rigorous evaluation and
collateralization.
3.The Size of the Bank:
✓ The size of the bank also affects its lending portfolio decision.
✓ Larger banks typically have more diversified loan portfolios, serving a wide
range of customers and industries.
✓ Smaller banks may focus on specific niche markets or sectors.
4.Economic Conditions:
✓ Economic conditions, both at the macroeconomic and industry levels, influence
lending decisions.
✓ Banks assess factors such as GDP growth, interest rates, unemployment rates,
industry trends, and market conditions to determine the creditworthiness of
borrowers and the potential risks associated with specific sectors.
5.Lending Policies of the Bank:
✓ Each bank has its own lending policies, which guide loan origination,
underwriting, and risk management practices.
✓ These policies define the bank's risk appetite, credit evaluation criteria, loan
monitoring procedures, collateral requirements, and loan approval processes.
6.Bank Size and Scope of Services:
✓ The size and scope of services offered by a bank impact its lending portfolio
decision.
✓ Banks with a broader range of services, such as commercial banking,
investment banking, and wealth management, may have more diverse lending
activities to meet the needs of their customers.
7.Participations:
✓ Banks may participate in syndicated loans or loan participations with other
financial institutions.
✓ Participations allow banks to share the risks and rewards of a loan, diversify
their lending exposure, and access larger lending opportunities that may exceed
their individual capacity.
8.Interest Rates and Credit Risk:
✓ Interest rates play a significant role in the lending decision.
✓ Banks consider the prevailing market interest rates, the cost of funds, and the
desired spread or margin when determining loan rates.
✓ Additionally, banks assess the credit risk associated with each loan to price it
accordingly.
9.Lending and Funding Strategies:
✓ Banks develop lending and funding strategies that align with their overall
business objectives and risk appetite.
✓ These strategies guide the bank's lending activities, target markets, loan types,
and funding sources.
✓ Strategies may include expansion into new markets, diversification of loan
portfolios, or focus on specific sectors or customer segments.

➢ Written Loan Policy:

✓ Banks typically have a written loan policy that outlines their lending guidelines
and procedures.
✓ The loan policy covers various aspects, including
- general lending principles,
-risk management practices,
-loan supervision and monitoring,
-geographic limits, and
- specific credit policies for different types of loans.

_________-end___________

What are the 6c’s of commercial lending?

1. Character(personal traits and attitudes about commitment to pay debt)

2. Capacity (borrower’s success at running a business- cash flows)
 3. Capital (financial condition of the borrower- net worth)
4. Collateral (pleged assets)
5. Conditions(economic conditions)
6. Compliance (compliance with laws & regulations such as the Community
Reinvestment Act, the Environment Superfund Act, lender liability etc)

1.Character:
✓ Character refers to the borrower's personal traits, integrity, and commitment to
repaying the debt.
✓ Lenders assess the borrower's credit history, reputation, and willingness to meet
financial obligations.
✓ It includes factors such as the borrower's credit score, payment history, and
references.

2.Capacity:
✓ Capacity evaluates the borrower's ability to repay the loan based on their
business's cash flow and financial performance.
✓ Lenders analyze the borrower's income statements, balance sheets, and financial
projections to determine if they have the capacity to generate enough cash flow
to service the debt.

3.Capital:
✓ Capital examines the borrower's financial condition and net worth.
✓ Lenders assess the borrower's equity investment in the business, retained
earnings, and overall financial stability.
✓ A higher capital investment indicates a stronger financial position and lowers
the lender's risk.

4.Collateral:
✓ Collateral represents the assets pledged by the borrower to secure the loan.
✓ Lenders evaluate the quality, value, and liquidity of the collateral.
✓ It serves as a secondary source of repayment for the lender in case of default.

5.Conditions:
✓ Conditions consider the external economic and industry factors that may impact
the borrower's ability to repay the loan.
✓ Lenders assess the overall economic conditions, market trends, industry risks,
and other factors.
- that could affect the borrower's business and ability to meet financial
obligations.

6.Compliance:
✓ Compliance focuses on the borrower's adherence to relevant laws and
regulations.
✓ Lenders consider the borrower's compliance with specific legal requirements,
such as the Community Reinvestment Act, environmental regulations, and other
applicable laws.
✓ Non-compliance can increase the lender's risk and may impact loan approval.
___end____