HOCHIMINH UNIVERSITY OF BANKING

CHAPTER 1.
PRINCIPLES OF LENDING AND
LENDING BASICS
By
Nguyen Thi My Hanh
 HOCHIMINH UNIVERSITY OF BANKING

LEARNING OBJECTIVES
• Identify the basic principles governing bank lending and explain their
importance
• Understand the framework within which credit and lending decisions are
taken
• Understand the lending process
• Explain the characteristics of various types of bank advance
• Distinguish different types if borrowers and the special considerations
that apply to them when giving loans
• Explain how advances are structured
• Explain the importance of credit culture in a lending institution
• Understand how an advance portfolio is designed
 HOCHIMINH UNIVERSITY OF BANKING

INTRODUCTION
There are several reasons that lending officers must acquire a
basic knowledge of lending:
• Principles of lending are not, therefore, theoretical concepts
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developed in academic institutions; rather, they have evolved
from the practice of lending in the real world.
• The lending discipline requires a framework within which
lending officers can operate. The lending principles provide
such a framework and have applications in real-world
situations.
• Lending principles enable us to study the subject of credit
analysis and lending systematically, and they thus serve to
guide appropriate lending decisions.
 HOCHIMINH UNIVERSITY OF BANKING

LENDING PRINCIPLES
An important of lending principles is their universal applicability.
Lending is often regarded as an art and not a science. Lending
principles are not laws of physical science that must hold
whatever be the case; rather, the principles serve as framework
within which to make a decision.
 HOCHIMINH UNIVERSITY OF BANKING

THE PRINCIPLES OF GOOD LENDING

The three principles that guide lending decisions are:

• Safety of loan
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Suitability of loan purpose
• Profitability
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SAFETY OF LOAN
This principle requires that a loan is granted to only that borrower
who is consider 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 circumstances
change so dramatically that assumption made when the loan is
made do not remain relevant. Lending institutions therefore often
require a back-up loan for the loan in the form of collateral
security.
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SUITABILITY OF LOAN PURPOSE

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 (e.g. narcotics
trade or gambling)
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.
 HOCHIMINH UNIVERSITY OF BANKING

PROFITABILITY

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
risks and returns from a possible loan.
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CREDIT ANALYSIS
Credit analysis can be done by traditional methods and/or modern
method. Modern methods use technology and this 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 (called the expert systems
method), the rating method and the credit scoring method.
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TRADITIONAL METHODS OF CREDIT ANALYSIS

Borrower’ credit assessment is done using the following criteria,
popularly known as the five Cs of lending:
• Character
• Capacity
• Capital
• Collateral
• Conditions
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CHARACTER
Character is the sum total of human qualities of honesty, integrity,
morality and so on. Lenders want to know whether borrowers are
morally honest or tricky, industrious or lazy, prudent or
speculative, thrifty or spendthrift, and whether they have other
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such qualities. These qualities combined constitute the character
of the borrower.
A person who is not honesty represents a risky proposition for a
lender, who will not know whether the money borrowed has been
put to the stated use.
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CHARACTER
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.
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.
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CHARACTER
Character assessment involves collecting information about the
borrower’s track record of integrity, repayment ability and
spending habits. Such information is collected not only in
personal loans, but also in business loans.
In personal loans, character assessment may seem 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 partnership, it involves assessing the character of all the
partners of the firm. In the case off joint stock companies, the
character of the directors of the company is assessed, and in the
case off a charitable trust, that of the trustees is assessed.

HOCHIMINH UNIVERSITY OF BANKING

CHARACTER
Integrity is another quality that is included in the concept of
character. If the borrower has integrity, then the lender can be
certain that the promise of repayment has integrity, then the
lender can be certain that the promise of repayment will be
honored.
Lenders judge integrity by the track record of the borrower. In
the context of businesses, the integrity of management is
assessed.
 HOCHIMINH UNIVERSITY OF BANKING

CHARACTER
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 may
possess excellent technical skills but lack business management
skills.
 HOCHIMINH UNIVERSITY OF BANKING

CHARACTER
A final aspect of characters is whether the borrower is spendthrift.
Company management are often criticized by ordinary
shareholders for extravagant spending. High salaries, high
business expenses, the use of expensive company cars and
business class travel are some of the indications of extravagent
spending.
 HOCHIMINH UNIVERSITY OF BANKING

CAPACITY
Capacity is the ability to repay the loan together with interest as
per the predetermined schedule. It depends on two factors: first,
the borrowers’ financial position should be sound and second, the
borrower must be able to generate sufficient net income to service
the loan repayment.
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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.
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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.
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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 affect the
repayment of a loan and need to be considered when a loan is
granted.
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RATING SYSTEMS
Loan-rating systems are called health codes of advances. The
ratings or codes are given on a 10-point scale. A rating of 1
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.
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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 quantitative scale) certain key factors
that determine the probability of repayment default. Cut-offs are
usually set to make a decision. The higher score, the better is the
loan quality and the lower is risk.
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MODERN APPROACHES TO CREDIT RISK MEASUREMENT

• Econometric techniques
• Optimization models
• Neural networks
• Hybrid systems
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ECONOMETRIC TECHNIQUES
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.
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OPTIMISATION MODELS

Optimisation models use mathematical programming techniques

to minimize lender error and thus maximise profits.
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NEURAL NETWORKS

Neural networks try to emulate the human decision-making

process using data as used in econometric techniques.
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HYBRID SYSTEMS

Hybrid systems involve establishing casual relationships by

estimating the parameters of such relationships (e.g.KMV model).
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A FRAMEWORK FOR CREDIT AND LENDING DECISION

• External factors affecting lending decisions

• Lending institution-specific factors
• Borrower-specific factors
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EXTERNAL FACTORS AFFECTING LENDING DECISIONS

• General law of the land. A financial institution cannot lend
for an unlawful activity.
• Macroeconomic factors. The general condition of the
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economy also affects the lending decisions. If the economy is
in recession, then lending institution 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.
 HOCHIMINH UNIVERSITY OF BANKING

LENDING INSTITUTION-SPECIFIC FACTORS

• 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 would be held accountable by the internal
audit department. The lending policy may specify the types of
advance that the institution prefers to grant.
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LENDING INSTITUTION-SPECIFIC FACTORS

• 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.
• Staff availability. Lending institutions may decide to restrict
their financing if they have a shortage of skilled staff to
appraise and monitor loans.
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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 requires the lending
officer to use judgement. Every borrower is different and his/her
circumstances are different too. Lending and credit decisions
have to be based on a consideration of several factors and, most
importantly, on the judgement of the lending officer.
Lending institution often prepare a lending manual, which they
occasionally update. The manual contains the above framework
in one form or the other.
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THE LENDING PROCESS

Step 1: Obtain the prescribed loan application form
Step 2: Obtain required documents/financial statements
Step 3: Check the loan application form and the
documents/financial statements for any obvious inconsistencies.
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 the stage.
Step 5: Appraise detailed technical, commercial, financial and
managerial aspects of the proposed business borrower.
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THE LENDING PROCESS

Step 6: Assess the financial requirements of the borrower
Step 7: If the proposal is approved, then send a letter conveying
the approval to the borrower, advising him/her to come the
branch to sign document.
Step 8: If the proposal is approved, then ensure that security and
other documents are duly signed before disbursing the loan.
Step 9: Monitor the account periodically.
Step 10: Where the operations in the loan account are not
satisfactory – be cautious and take steps before the account turns
into a problem loan.
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TRADITIONAL TYPES OF ADVANCE

There are broadly two types of advance: loans and overdraft.

Loans are generally made in one lump sum and are repayable by
installment over a period of time.
An overdraft is a running account, which can go into debit and
come back into credit.
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MODERN TYPES OF ADVANCE FOR BUSINESS

Business borrowers can also be financed by modern methods,

which include equity participation, equipment leasing, factoring
an loan syndications.
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EQUITY PARTICIPATION
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.
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LOAN SYNDICATION
Loan syndication involves two or more lenders jointly meeting the
large financial 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 form 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 percent of
their capital.
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EQUIPMENT LEASING
If a corporation wants to buy capital goods such as aircraft, then it
may take a conventional loan from a bank or enter into an
industrial hire purchase 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 lender, but the borrower
has possession. 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.
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FACTORING
Factoring is the purchase of debts by a lending institution. The
lender purchases 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 collecting trade business.
Before purchasing debts, the lender will scrutinize the list of
debtors, delete any debts that may be hard to collect and
purchase the remainder.
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TYPES OF BORROWER
Principally there are two types of borrowers: personal borrowers
and business borrowers.
Individuals and households are considered to be personal
borrowers.
Business borrowers may take forms, including a sole
proprietorship, partnership, limited company and so on.
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PERSONAL BORROWERS
Personal borrowers can be individuals, household 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.
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PERSONAL BORROWERS
Husband and wife
The rights and responsibilities of husband and wife are similar to
those of other joint account holder. 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.
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BUSINESS BORROWERS

• Sole proprietorship
• Partnerships
• Companies
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SOLE PROPRIETORSHIP
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 HR Bruce and Co, for example, in
which case he has to sign as the sole proprietor 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.
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PARTNERSHIP
A partnership is a relation between persons who have agreed to
share the profits of the business carried on by all or any one of
them acting for all. Another name for partnership is ‘firm’. A
partner is an agent of the firm for the purpose of the 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.
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PARTNERSHIP
A partnership may be dissolved by circumstances provided in the
partnership 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 the 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.
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COMPANIES
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 authorized person and has the authority
conferred by a special resolution from the company’s board of
directors. Generally, the managing director and the company
secretary are authorized officials who act on behalf of the
company.
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COMPANIES
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.
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STRUCTURING OF ADVANCES

Structuring an advance involves three major aspects: obtaining

security, deciding on the debt covenants and pricing.
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SECURITY
Common forms of security include:
• Land and improvement 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 mortgage
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DEBT COVENANTS
The standard covenants included in loan contracts are:
• Fees and interest rates
• Any security/insurance
• Repayments and actions in case of default
• Stamp duty and government charges
Sometimes, negative pledges are add 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
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PRICING ISSUES
Lenders generally charge the following fees:
• An establishment fee
• An application fee
• A loan administration fee
• An unused limit fee
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CREDIT CULTURE
A credit culture means the institutional priorities, traditions and
philosophies that surround credit or lending decisions.
A strong credit culture helps lending institution manage credit
risk effectively and gives it a competitive advantage in the
marketplace.
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CREDIT CULTURE
Take Banc One as an example. It 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 organization’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
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DESIGNING AN ADVANCES PORTFOLIO

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 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?
 HOCHIMINH UNIVERSITY OF BANKING

DESIGNING AN ADVANCES PORTFOLIO

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 design loan portfolio.
The important ones include the KMW’s portfolio manager,
CreditMertrics, VAR, RAROC and EVA.