BANK LENDING

Tran Thi Minh Tram

Email: tramttm@ftu.edu.vn

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Chapter 1: The principles of
lending and lending basics
BANKS AS LENDERS

DIFFERENT TYPES OF BORROWERS

CATEGORIES OF LENDING

THE PRINCIPLES OF GOOD LENDING

THE LENDING PROCESS

STRUCTURING OF ADVANCES,
DESIGNING AN ADVANCE PORTFOLIO 2
Learning objectives
By the end of this chapter you should be able to:
• 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 of 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 advances portfolio is designed
THE BUSINESS OF BANKING
• Banks are still preeminent in the financial system . . . [and] are vital to
economic activity, because they reallocate money, or credit, from savers,
who have a temporary surplus of it, to borrowers, who can make better
use of it . . . [and by] collaborating to clear payments, they help
individuals and firms fulfill transactions.
—The Economist1

• Banking is a business like any other—a raw material (in this case money)
goes into the process we call banking, and hopefully, a profit . . . comes
out . . . the other end.
—Howard Palmer2

• A bank is a place that will lend you money if you can prove that you
don’t need it.
—Bob Hope, comedian and actor (1903–2003)3

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Question:
• How banks add value?
• Sources of bank revenue: interest income versus
noninterest income?

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Sources of bank revenue

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BANKS AS LENDERS
• Lending is the institution’s main business from
history till now.
• Traditional loans comprise the bulk of the average
bank’s financial assets.
• Much of the risk borne by the bank is credit risk.

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Bank lending
• Lending (also known as "financing") occurs when
someone allows another person to borrow
something. Money, property, or another asset is
given by the lender to the borrower, with the
expectation that the borrower will either return the
asset or repay the lender.

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DIFFERENT TYPES OF BORROWERS
• Personal borrowers
• Minors
• Persons of unsound mind
• Insolvents
• Joint accounts
• Husband and wife
• Business borrowers
• Sole proprietorship
• Partnership
• Companies
• Special types of borrower
• Local authorities
• Clubs, literary societies and schools
• Unincorporated associations
• Co-operatives

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Question:
• Distinguish different types of borrowers and the
special considerations that apply to them when
giving loans?

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CATEGORIES OF LENDING
• In general, credit products can be categorized as
following:
• Tenor: short term vs. long term
• Collateral: secured vs. unsecured
• Currency: local vs. foreign
• Legal obligation: committed vs uncommitted

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Categories of Lending
• By purpose of loan: what customers plan to do with the
proceeds of their loans
• By maturity of loan: length of borrowing-lending time (i.e.,
short-term versus long-term)
• By collateral (i.e., secured versus unsecured)
• By their pricing terms (i.e., floating-rate versus fixed-rate loans)
• By financing vehicle/Product type
• Traditional products
• Syndicated lending
• Securitization…
• By customer franchise (By types of customers, By business
sectors)
• Industry sector (e.g., agriculture, heavy industry)
• Broad product categories—such as loans, receivables finance,
documentary trade finance
• Customer base to which they are marketed, such as consumers, small
business, or blue-chip industrials 12
Categories of Lending

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TABLE 16–1 Loans Outstanding for All FDIC-Insured Banks as of
December 31, 2010 (consolidated domestic and foreign offices)

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E.g.: ACB

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E.g.: ACB

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Loans versus other credit products
and facilities
• Loans
• A loan can be defined as a legally binding agreement
between a lender and a borrower under which the
lender advances a certain sum of money to the
borrower for a certain period and the borrower
promises to repay the sum advanced—the principal—
with interest as provided in the loan agreement.

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Loans versus other credit products
and facilities
• Other Credit Products
• However, credit can also be provided to a customer
through other legal mechanisms—for example, a
financial lease.
• The mechanisms and structures that form the universe
of products through which a financial institution
provides credit to customers are frequently referred to
collectively as credit facilities or, more broadly, as credit
products—often shortened to facilities or products.

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Loans versus other credit products
and facilities
• Facilities
• A facility can therefore be defined as an arrangement
made by a financial institution with a customer to
provide a given type of credit support.
• The term facility embraces a broader group of credit
products than loans.
• Example: overdraft facility
• An overdraft facility is a credit arrangement under which a
bank advances funds to a borrower in varying amounts up to a
specified limit, and the latter’s repayment obligations are,
within predefined parameters, flexible.

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Different types of advance
• Types in summary:
• Loans
• Loans classified according to security
• Loans classified according to type of borrower
• Loans classified according to the term of the loan
• Loans classified according to sector
• Loans classified according to region
• Loans classified according to purpose
• …
• Lines of credit
• Asset-Based and Receivables Finance
• Modern types of advance for business
• Equity participation
• Loan syndication
• Equipment leasing
• Factoring
• …
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 Loans
• Term loans represent the simplest type of loan, being for
a fixed term.
• Rollover loans are essentially term loans that renew upon
maturity according to predetermined criteria.
• Call loans, in contrast to rollover loans and term loans,
may be terminated before maturity by either party, but
notably by the lender.
• Short-term advances usually are working capital loans,
sometimes part of a larger arrangement, with a maturity
not exceeding one year.
• Bridge loans are a type of short-term advance that is
advanced in contemplation of longer-term funding being
put in place.
•…
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Loans
• Define:
• Product Type
• Definition
• Typical Terms and Usage
• Risks

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Loans
• Product Type: Term loan
• Definition: Normally extended for a period of one year or more, a term
loan constitutes an agreement by the borrower to repay to the bank the
principal sum advanced at the end of the loan term, together with
interest, at either a fixed or variable rate, in the form of a balloon
(bullet) payment or on a periodic (e.g., monthly, quarterly) basis. An
amortizing term loan means that the principal balance is gradually
reduced during the term of the loan.
• Typical Terms and Usage: Term loans are primarily used for long-term
(i.e., more than one year) financing requirements such as for capital
expenditures. Usually from 1- to 5-year maturity, although 7 to 10 years
or longer is not unknown. Loans with bullet repayment terms usually
require a higher standard of creditworthiness on the part of the
borrower, and should be appropriate to the customer’s situation.
• Risks: Loss of principal advanced and anticipated interest payments.
Loss exposure will decline over time on an amortizing loan, whereas
exposure risk for loan with bullet terms in respect of principal and
interest will remain constant until maturity.

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Loans
• Product Type: Rollover loan
• Definition: A rollover loan is a special category of term loan,
equivalent to a revolving line of credit. The interest rate of the
rollover loan is fixed for a limited period of time, usually ranging
from one month to one year. Preagreed extensions of the loan
(rollovers) are periodically set prior to the next succeeding term
based on predefined criteria, e.g., an interbank interest rate such
as LIBOR plus a risk premium appropriate to the borrower’s credit
standing.
• Typical Terms and Usage: Like term loans, the maturity of rollover
loans may be as long as 7 to 10 years, but they may also be used
for short-term credit provisions in response to a customer’s
working capital needs.
• Risks: As with term loans, the exposure risk will vary according to
the amount of principal and interest outstanding in accord with
the loan provisions.

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Loans
• Product Type: Short-term advance
• Definition: short-term advance is simply a loan
extended for a period of between one day and one
year whereby a single bullet payment is made at
maturity. A short-term advance may constitute a part
of a larger credit arrangement such as a revolving line
of credit.
• Typical Terms and Usage: Customarily, short-term
advances are either for a round number of months or
days and used for working capital finance or other
short-term needs.
• Risks: Since short-term advances employ bullet
repayment terms, exposure will be equal to the full
amount of unpaid principal and interest.
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Loans
• Product Type: Call loan
• Definition: A call loan is a loan extended for an
indefinite period, which may be terminated at any time
by either party upon notice according to the loan
terms.
• Typical Terms and Usage: Call loans are generally used
for temporary financing needs of an uncertain duration.
Typically, notice of termination of a call loan may be
given every day before 12.00 A.M., in which case final
repayment must be made within two working days.
• Risks: Since call loans have no fixed duration, exposure
risk excludes anticipated future interest income beyond
the notice period.

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Loans
• Product Type: Bridge loan
• Definition: A bridge loan is a type of short-term
advance utilized to cover an anticipated gap between
the time payment arising from a given transaction is
confirmed and the actual receipt of the proceeds
pursuant to the settlement of the transaction.
• Typical Terms and Usage: Since the duration of the
period between consummation of the transaction and
settlement can be estimated with some high degree of
probability, bridge loans are usually of a fixed term,
often less than one month.
• Risks: Same as other short-term advances of fixed
maturity.

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Lines of Credit
• A line of credit is a commitment by a financial
institution to advance funds up to a designated
maximum during a given period.
• Facilities that fall under the broad category of lines
of credit include:
• Overdraft facilities
• Revolving credit facilities
• Standby facilities or standby rollover facilities
• Multipurpose facilities
• Specialized facilities (e.g., note issuance facilities
liquidity support facilities)

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Question:
• Compare lines of credit with rollover loan and
term loan?

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Facility
• Define:
• Product Type
• Definition
• Typical Terms and Usage
• Risks

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Facility
• Product Type: Overdraft facility
• Definition: An overdraft facility is a credit arrangement under which a
bank advances funds to a borrower in varying amounts up to a specified
limit, and the latter’s repayment obligations are, within predefined
parameters, flexible. That is, within specified limits, the date and
amount repaid within any given financial period is not fixed but may
vary according to the customer’s needs. An overdraft facility may be a
discrete product, or part of another credit product.
• Typical Terms and Usage: Overdraft facilities are most commonly used
to provide working capital to companies through the cycle of
manufacturing or providing goods or services and converting them into
collected cash. The limits on overdraft facilities are customarily reset on
an annual or similar periodic basis. Note that of the facilities described
in this table, the overdraft facility generally affords the greatest
flexibility in drawdown and in repayment.
• Risks: Unlike many loan products, the credit exposure in respect of
overdraft facilities and other similar lines of credit incorporates a
maximum or nominal exposure figure equal to the amount of credit
advance permitted under the facility and the expected exposure.
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Facility
• Product Type: Revolving credit facility
• Definition: A revolving credit facility is quite similar to a
rollover loan, described in the previous table, the main
difference being that revolving credit facilities do not
have maturities of greater than five years.
• Typical Terms and Usage: Like term loans, the maturity
of rollover loans may be as long as 7–10 years, but
they may also be used for shortterm credit provisions in
response to a customer’s working capital needs.
• Risks:

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Facility
• Product Type: Standby facility/ Standby rollover facility
• Definition: A standby facility is similar to an overdraft facility but differs
in that its tenor may be longer than is customary with the latter in
order to meet the particular needs for which it is obtained. Exposure for
a standby facility is incurred both during the period in which it may be
exercised and during the period in which, if drawn upon, funds must be
repaid. In addition the facility may be provided on a multicurrency basis.
Repayment terms, however, are usually fixed rather than flexible. A
standby rollover facility is a standby facility structured with a view to
being extended on a rollover basis.
• Typical Terms and Usage: A standby facility is typically used for backup
purposes to provide a customer with assurance that credit will be
available for a period of time, often in order to ensure the customer’s
ability to consummate a major transaction such as a large investment or
acquisition.
• Risks:

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Facility
• Product Type: Multipurpose facility
• Definition: A multipurpose facility is a variant
facility that may incorporate characteristics of
overdraft facilities, revolving credit facilities, and
standby facilities.
• Typical Terms and Usage: Multipurpose facilities
are used to provide both working capital and
longer-term finance to customers.
• Risks

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Facility
• Product Type: Specialized facilities
• Definition: These include note-issuance facilities and
liquiditysupport facilities. Note-issuance facilities are
provided in connection with a note-issuance program
whereby a bank or a group of banks underwrites a
borrower’s issuance of short- or medium-term notes in
the money or capital markets. Liquidity-support
facilities are used to provide liquidity in connection
with securitizations such as the origination by a
customer of mortgagebacked securities (MBS).
• Typical Terms and Usage
• Risks
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Asset-Based and Receivables
Finance
• Asset-based or receivables financing are commonly
provided to merchants and to manufacturers to
finance domestic and overseas trade, and therefore
may be categorized as types of export financing or
commodity financing.
• Asset-based and receivables finance instruments:
• Acceptance borrowing (bankers’ acceptances…)
• Commodity financing
• Export financing (trade finance and Letter of Credit…)

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Asset-Based and Receivables
Finance
• Define:
• Product Type
• Definition
• Typical Terms and Usage
• Risks

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Asset-Based and Receivables
Finance
• Product Type : Acceptance borrowing (bankers’ acceptances)
• Definition: Acceptance borrowing refers to the use of bankers’
acceptances, also known as bills of exchange (technically speaking, the
instrument can be classified as a negotiable time draft), to finance the
import or export of goods. The instrument is called an acceptance
because by its terms it obligates the bank that accepts it to pay its face
value to the bearer of the instrument at maturity.
• Typical Terms and Usage : One of the oldest forms of finance, bankers’
acceptances (bills of exchange) facilitate trade by allowing the merchant
to substitute a recognized bank’s creditworthiness for its own. This
rendered the instruments negotiable (marketable), and historically bills
of exchange functioned as a form of money to consummate transactions
in lieu of coin or currency. Modern bankers’ acceptances ordinarily have
a maximum tenor of six months.
• Risks
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Asset-Based and Receivables
Finance
• Product Type : Commodity financing
• Definition: Commodity financing refers to the financing of a
designated quantity of commodities such as agricultural products,
mineral products, petroleum products, and so on in advance of
sale. Hence, they are ordinarily short-term in character.
• Typical Terms and Usage : The title documents (e.g., warehouse
receipt, bill of lading) to the commodities to be sold function as
collateral for the loan. As a rule, the commodities are required to
be stored at a bonded warehouse, in which case a warehouse
receipt serves as title to the goods.
• Risks

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Asset-Based and Receivables
Finance
• Product Type : Export financing
• Definition: Export financing encompasses a number of products,
including loans directly to exporters, for further extension to
importers, or directly to the importers or their banks.
• Typical Terms and Usage : Export loans are a form of credit that
is primarily used to finance the export of capital goods where it is
contemplated that the overseas purchaser will not pay the entire
cost of the goods at delivery, but will finance the balance of the
purchase over some period of time, typically more than one year.
To mitigate risks, export credit insurance provided by export
credit agencies, is purchased.
• Risks

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Trade finance
• Trade finance relates to financial activities designed
to support and facilitate commerce and
international trade.
• In essence, trade finance works by reconciling the
divergent needs of exporters and importers.

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Trade finance

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Syndicated Lending
• Syndicated lending/loan syndication involves two
or more lenders jointly meeting the large financial
needs of a corporate customer.
• There could be several reasons for this difficulty:
resources, risk, regulations…

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Syndicated lending

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Syndicated Lending

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Syndicated lending

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Credit ratings

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Questions
• Compare syndicated lending with public debt
issues?
• Rationale for syndicated lending?

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Lease finance
• Financial leasing/ Equipment leasing/ Finance
leases have a different legal form from loans but
have a quite similar function.
• A lease is a contract under which the lessor (lender)
hires out specific equipment to a lessee (borrower).
The lessee then make periodic payments to the
lessor. At the end of the lease period, it may
exercise the option to take full title to the
equipment.

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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.

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Securitization
• Securitization began in the 1970s, grew explosively
during the 1980s and 1990s.
• Through securitization, loans—traditionally illiquid
assets—are aggregated into pools and repackaged
into new relatively liquid securities that are sold to
investors.

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‘New’ credit products and
securitisation
• The development of a wider range of ‘new’ credit
products
– For instance: bonds, syndicated loans, mortgages, credit card
receivables… are bundled together and sold as a security in
the market.
– Credit derivatives:
o Credit default swaps (CDS)
o Collateralized debt obligations (CDO)
o Total return swaps
o Credit default swap options
o Credit spread forward
• There is a securitisation trend, especially some high
profile bank loan securitisations (mainly in the form of
CDOs- Collateralised Debt Obligations)

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54
Questions
• Rationale for securitization?
• Process of securitization?

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Credit Cards
• A credit card is a line of unsecured credit evidenced
to merchants by means of a plastic card that
contains identifying data about the facility that has
been established with the card issuer.

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Credit Cards

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Question
• Advantages of credit card?

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 16-59

Factors determining the growth and

mix of lending (loans)
• Characteristics of the market area
• Lender size (Wholesale lenders vs. retail credit)
• Experience and expertise of management (type of
lending institution involved)
• Loan policy
• Expected yield of each type of loan
• Regulation

▫ General rule: A lending institution should make the types

of loans for which it is the most efficient producer
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Example
• A lender's cost accounting system reveals that its
losses on real estate loans average 0.45 percent of
loan volume and its operating expenses from
making these loans average 1.85 percent of loan
volume. If the gross yield on real estate loans is
currently 8.80 percent, what is this lender's net
yield on these loans?

Small banks have higher net yields than large banks?

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THE PRINCIPLES OF GOOD
LENDING
• Safety of loan
• Suitability of loan purpose
• Profitability

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Lending principles
• For a proper understanding of credit analysis and
lending management, one must acquire a basic
knowledge of the principles of lending.
• Principles of lending are not theoretical concepts
developed in academic situations; rather, they have
evolved from the practice of lending in the real world.
• Lending principles provide a framework within which
lending officers can operate.
• Lending principles have applications in real-world
situations.
• Lending principles serve to guide appropriate lending
decisions.

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Lending principles
• An important aspect of lending principles is their
universal applicability.
• Is there no scope for personal judgements?
• Lending is an art, and not a science, is that right?

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A framework for credit and lending
decisions

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 16-65

Regulation of lending
• The mix, quality, and yield of the loan
portfolio are heavily influenced by regulation.
• Examples of lending regulations:
▫ Total loan to a single customer normally cannot
exceed 15 percent of a single bank’s equity (legal
lending limit)
• Any loans made are subject to examination
and review.

Why is lending so closely regulated by state and federal authorities?

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 16-66

Regulation of lending
• Uniform Financial Institutions Rating System
▫ Each banking firm is assigned a numerical rating
based on the quality of its asset portfolio
▫ The federal examiner may assign one of these
ratings:
▪ 1 = strong performance
▪ 2 = satisfactory performance
▪ 3 = fair performance
▪ 4 = marginal performance
▪ 5 = unsatisfactory performance
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 16-67

Regulation of lending
• Asset Quality
▫ Criticized loans: good but not in full compliance
with the bank’s loan policy
▫ Scheduled loans: significant weaknesses (credit
concentration in a borrower or an industry)
▫ Adversely classified loans
▫ Substandard loans: problems with repayment abilities &
collateral
▫ Doubtful loans: high probability of uncollectible loss
▫ Loss loans: uncollectible

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 16-68

Regulation of lending
• CAMELS Rating
▫ Capital adequacy
▫ Asset quality
▫ Management quality
▫ Earnings record
▫ Liquidity position
▫ Sensitivity to market risk exposure
• All six dimensions of performance are combined
into one overall numerical rating, referred to as
the CAMELS rating
▫ Depository institutions whose overall rating is
low (4,5) tend to be examined more frequently
than the highest-rated institutions (1,2,3)
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 16-69

Establishing a good written loan

policy
• Important in order to meet regulatory standards
• What should a written loan policy contain?
▫ A goal statement for the entire loan portfolio
▫ Specification of lending authority of each loan officer and
loan committee
▫ Lines of responsibility in making assignments and
reporting information
▫ Operating procedures for soliciting, evaluating and
making loan decisions
▫ Required documentation for all loans

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 16-70

Establishing a good written loan

policy
▫ Lines of authority for maintaining and reviewing credit
files
▫ Guidelines for taking, evaluating, and perfecting loan
collateral.
▫ Procedures for setting loan rates and fees and the terms
for repayment of loans
▫ A statement of quality standards applicable to all loans
▫ A statement of the preferred upper limit for total loans
outstanding
▫ A description of the lending institution’s principal trade
area
▫ Procedures for detecting and working out problem loan
situations.
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 THE PROCESS
• Credit origination
• Credit analysis
• Credit management

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72
Steps in lending process
1. Find prospective customers
• Individuals: normally come to the bank
• Business loans: through “salespeople” contacts
2. Evaluate customer’s character and sincerity of
purpose
• Interview: customer explains his credit needs
• Loan officer to assess customer’s sincerity
3. Make site visit & evaluate credit records of
customer
• Location and condition of property
• Records of customer’s previous loans
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Steps in lending process
4. Evaluate customer’s financial condition
• Does customer have sufficient cash flow and backup
assets to repay the loan?
5. Assess collateral & sign the loan agreement
6. Monitor customer’s compliance with the
agreement
• Ensure terms are being followed, principal and interest
are paid in time
• Visit customer’s & explore new opportunities

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75
The lending process
• To make the activity profitable, funds must be
sourced at a reasonable cost to lend to financially
sound borrowers.

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STRUCTURING OF ADVANCES
• Security
• Debt covenants
• Pricing issues

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CREDIT CULTURE
• Culture means a stratum of linked attitudes,
responses and behavioural patterns within an
organisation.
• Credit culture means the institutional priorities,
traditions and philosophies that surround credit or
lending decisions.

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DESIGNING AN ADVANCE
PORTFOLIO
• Financial institutions generally follow three
approaches in designing loans and advances
portfolios.
• Historical or recent loss experience
• Standards based on maximum loss tolerance relative to
capital
• 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

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Summary
• A lender 'lends' money and does not give it away.
o A lender receives income from the interest and fee income the loan generates.
o The purpose is NOT to obtain the underlying asset/security (that is how lenders LOSE
money).
• There is a judgment therefore that at some future date repayment will take
place.
• The lender needs to look into the future and ask, will the customer repay by the
agreed date?
• As forecasting is at best imperfect not all loans will be repaid on time as
contracted.
• The lender's objective will be to assess the extent of the risk and to try to
reduce the amount of uncertainty that will exist over the prospect of
repayment.
• Put another way, the objectives of loan assessment and structuring are to
• (i) reduce the loan portfolio default rate to an acceptable minimum and
• (ii) to reduce the costs when something goes wrong.

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PREPARE FOR CHAPTER 2
1. Reading documents

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