CREDIT POLICIES AND

PROCEDURES: MANAGING
CREDIT RISK

Chapter 5

William Chittenden edited and updated the PowerPoint slides for this edition.
 16-2

Key topics

1. Types of loans banks make

2. Factors affecting the mix of loans made

3. Regulation of lending

4. Creating a written loan policy

5. Steps in the lending process

6. Loan review and loan workouts

 16-3

Types of loans made by banks

 Real estate loans

 Commercial and industrial loans
 Loans to individuals
 Financial institution loans
 Agriculture loans
 Miscellaneous loans
 Lease financing receivables
 16-4

Loans outstanding for U.S. Banks (2007)

 16-5

Factors determining the mix of bank loans

 Characteristics of market area: most lenders are

chartered to serve selected markets where they are
located as suburban community (residential real estate
loans, automobile loans, credit for home appliances) or
central city (business loans for inventory, equipment
purchase, business payrolls)

 Lender size: legal lending limit to single borrower.

 Larger banks → wholesale lenders

 Smaller banks → retail credit

 16-6

Factors determining the mix of bank loans (cont.)

 Experience and expertise of management and
loan policy: commercial banks tend to have
experience and lending policy to make large numbers
of commercial and industrial (business) loans
 Expected yield of each type of loan: lenders
prefer to make loans bearing the highest expected
returns (highest net yields: real estate & commercial loans)
 Regulations: any loans made are subject to
examination and reviewed and many are restricted or
even prohibited by law.
 16-7

Regulation of lending: CAMELS rating system

 Capital adequacy
 Asset quality
 Management quality
 Earnings record
 Liquidity position
 Sensitivity to market risk
 16-8

Asset quality

 Criticized loans: performing well but lender

have minor weakness
 Scheduled loans: containing significant
weakness or showing dangerous
concentration of credit in a borrower/industry
 16-9

Asset quality

 Adversely classified loans: carrying risk of not paying out as

planned
 Substandard loans: margin of protection is inadequate due to
weakness in collateral of the borrower’s repayment abilities
 Doubtful loans: carrying a strong probability of loss
 Loss loans: uncollectible or unsuitable to be called as
bankable assets
 16-10

Regulators’ use of market forces

Because the quality of examination information

decays very quickly, regulators are starting to use
market forces and private market discipline (e.g.
borrowing costs, stock prices) to monitor bank
behavior.
Quick quiz

1. Why is lending closely regulated by authorities?

2. How loans are classified by risk level in VN? What

is the purpose of loan classification?

3. What is the CAMELS rating and how is it used?

 Loan classification by risk
1. Pass/Current: Loans for which borrowers are current in meeting
commitments and for which the full repayment of interest and principal
is not in doubt.
2. Special Mention: Loans with which borrowers are experiencing
difficulties and which may threaten the authorized institution's
position.
3. Substandard: Loans in which borrowers are displaying a definable
weakness that is likely to jeopardise repayment.
4. Doubtful: Loans for which full collection is improbable, the authorized
institution expects to sustain a loss of principal and/or interest, taking
into account net realisable value of collateral.
5. Loss: Loans that are considered uncollectable after all collection
options (such as the realisation of collateral or the institution of legal
proceedings) have been exhausted.
 16-13

Vietnam – Loan classification

1. By tenor: short-, medium- & long-term
2. By credit form: lending, discounting, leasing &
guarantee
3. By assurance: trust-based & collateral-based loans
4. By risk level: 5 loan groups
5. By borrowing purpose: business & consumption loans
6. By business fields: agricultural, construction,
transportation, etc.
7. By customer size: big enterprises and SMEs
…..
→ for credit management because of the importance and
complication of credit
 16-14

Establishing a good written loan policy

1. Goal statement for bank’s loan portfolio

2. Specification of lending authority of each loan
officer and committee
3. Lines of responsibility in making assignments and
reporting information
4. Operating procedures for soliciting, evaluating and
making loan decisions
5. Required documentation for all loans
6. Lines of authority for maintaining and reviewing
credit files
 16-15

Bank’s written loan policy (cont.)

7. Guidelines for taking and perfecting collateral

8. Procedures for setting loan interest rate
9. Statement of quality standards for all loans
10. Statement of upper limit for total loans
outstanding
11. Description of the bank’s principal trade area
12. Procedures for detecting, analyzing and working
out problem loans
 16-16

Steps in the lending process

1. Finding prospective loan customers
2. Evaluating a customer’s character and sincerity
of purpose
3. Making site visits and evaluating a customer’s
credit record
4. Evaluating a customer’s financial record
5. Assessing possible loan collateral and signing
the loan agreement
6. Monitoring compliance with the loan agreement
and other customer service needs
 16-17

The Six basic C’s of lending

 Character – specific purpose of loan and serious
intent to repay loan
 Capacity – legal authority to sign binding contract
 Cash – ability to generate enough cash to repay
loan
 Collateral – adequate assets to support the loan
 Conditions – economic conditions faced by
borrower
 Control – does loan meet written loan policy and
how would loan be affected by changing laws and
regulations
16-18
 16-19

Common types of loan collateral

 Reasons for taking collateral:

 Proceeds of collateral sale is to cover loans
 Collateralization gives lenders a psychological
advantage over the borrower
 The lender’s perfected claim: a lender holds
claim standing superior to claims of other lenders
and the borrower’s own claim.
 Procedures for establishing a perfected claim
depends on the nature of assets and laws of the
place where the asset reside.
 16-20

Common types of loan collateral

 Types of collateral:

 Accounts receivables
 Factoring

 Inventory

 Real property
 Personal property
 Personal guarantees
Safety zone

 Loans exposing to risk should be protected by

1. Deposits maintained by the borrower

2. The borrower’s expected profits, income or cash

flow

3. Strength of the borrower’s balance sheet liquidity

or collateral pledged

4. Personal guarantees and pledges made by a

third party
 16-22

Information about consumers

 Consumer-supplied financial statements

 Credit bureau reports
 Experience of other lenders
 Verification of employment
 Verification of property ownership
 The web
 16-23

Information about businesses

 Financial reports supplied by the borrowing firm
 Copies of board of director’s resolutions or
partnership agreements
 Credit ratings – Dun & Bradstreet, Moody’s,
Standard & Poor’s
 New York Times, Wall Street Journal, other
business publications
 Risk management associates (RMA), Dun &
Bradstreet industry averages
 The world wide web
 16-24

Information about governments

 Government budget reports

 Credit ratings assigned to government
borrowers by Moody’s, Standard & Poor’s, Fitch
 Web
 16-25

Lending the old fashioned way? (box)

 Traditional lending model
 Deregulation of the 1980s and 1990s
 New lending model
 Financial innovations, such as securitization, and
their effect on lending mix and policies
(“streamlined” loans)
 Mortgage market problems, 2007
 Newer lending paradigm or back to the basics?
 An increased coordination among financial
regulators in different countries
 Quick quiz

1. What is the role of a loan policy to a lending institutions?

2. What are the differences between Accounts receivable

and Factoring as loan collateral?

3. What are the differences between Personal Property

and Personal guarantees as loan collateral?

Accounts receivable
 Account receivables are used as collateral and loans
are repaid when the buyers pay their debts
 Most lenders do not require a business plan or tax
documents to make this type of loan
 Lender calculate a loan-to-value ratio, differing from
lenders to lenders
 Some lenders may refuse to finance accounts that have
aged beyond 90 days, or may assign a lower
percentage to older accounts
 If a loan goes into default, the lenders may seize the
receivables used to secure the loan

http://www.toolkit.com/small_business_guide/sbg.aspx?nid=P10_3710
 Factoring
 Factoring is the process of purchasing invoices from a business at a
certain discount.
 Factors provide financing service to small and medium-sized companies
who need cash.
 A fee is charged equal to a percentage of the invoices purchased,
generally 5%. The factor may retain 20% of invoice before paying full
amount when getting fully paid by the buyers.
 Factoring is a low value short term financing forms. It involves the
purchase of invoices, for an amount less than $10,000 an 90-120 days
payment terms.
 After shipping your goods or services, the factor purchases the invoices,
and advances cash to you company.
 Normally conducted in a recourse basis: factors can recover payment
from the sellers if the buyers refuse to pay.
 Factoring provide liquid assets to small business.
http://www.tapchiketoan.com/ngan-hang-tai-chinh/thi-truong-tai-chinh/phat-trien-
nghiep-vu-factoring-nham-da-dang-hoa-hoat-dong-cua-ngan-hang-o-vie.html
Personal Property and Personal guarantees

 Personal Property: the borrower is also the

property owner
 Personal guarantees: the borrower (the
business entity) is NOT the property owner
 16-30

Parts of a typical loan agreement

 The promissory note: specifying loan amount,

interest rate, repayment terms,…
 Loan commitment agreement: lender promise to
make credit available in return for a commitment fee
 Collateral: some borrower’s property pledged to be
sold if the loan is unpaid.
 Covenants
 Affirmative: borrower is to take certain actions
 Negative: borrower is restricted from doing
certain things without lender approval
Sample loan covenants
Negative
 Capital outlays cannot exceed $3
million annually
 Cash dividends cannot exceed 60%
of periodic earnings
 Total officers' salaries cannot exceed
$500,000 annually
 No liens on assets beyond existing
liens
 No mergers, consolidations, or
acquisitions without bank approval
 No sale, lease, or transfer of more
than 10% of existing assets
 No change in senior management
 No additional debt without bank
approval
Affirmative
 Borrower must maintain following financial
ratios:
Current ratio >1.0
Days receivables outstanding <50 days
Inventory turnover >4.5 times
Debt to total assets <70%
Net worth >$1 million
Fixed charge coverage >1.3 times
Cash flow from operations >dividends
+ current maturities of long-term debt
 Certified financial statements must be provided
within 60 days of end of each fiscal year
 Borrower will maintain $500,000 key man life
insurance policy on company president, with bank
named as beneficiary
 Bank will be allowed to inspect inventory,
receivables, and property periodically
 Borrower must pay all taxes and government fees,
unless contested in good faith, and comply with
all laws
 Borrower must inform bank of any litigation or
claim that might materially affect its performance
 Borrower must maintain all property in good
condition and repair
 16-32

Parts of a typical loan agreement (cont.)

 Borrower guaranties and warranties: borrower

guarantee that information supplied in the loan
application is correct
 Events of default: specifying
 actions or inactions by the borrower that would
represent a significant violation of loan agreement
 Actions that the lender is legally authorized to
take in order to secure the loan
 16-33

Loan review
 Examination of outstanding loans to make sure
borrowers are adhering to their credit agreements,
the bank is following its own loan policies and to
handle problem loans.
 Loan review should be kept separate from credit
analysis, execution, and administration
 The loan review committee should act
independent of loan officers and report directly to
the CEO of the bank.
 16-34

Loan review procedures

1. Carrying out review of all types of loans on a
periodic basis
2. Structuring the loan process
 Record of borrower payments
 Quality and condition of collateral
 Completeness of loan documentation
 Evaluation of borrower’s financial condition
 Assessment as to whether loan fits with
lender’s loan policies
 16-35

Loan review procedures (cont.)

3. Reviewing largest loans most frequently

4. Conducting more frequent reviews of troubled

loans

5. Accelerating the loan review schedule if

economy or industry experiences problems

 16-36

Warning signs of problem loans

1. Unusual or unexpected delays in receiving financial

statements
2. Any sudden changes in accounting methods
3. Restructuring debt or eliminating dividend
payments or changes in credit rating
4. Adverse changes in the price of stock
5. Losses in one or more years
6. Adverse changes in capital structure
7. Deviations in actual sales from predictions
8. Unexpected and unexplained changes in deposits
 16-37

Loan workouts

The process of resolving a troubled loan so the

bank can recover its funds
 16-38

Loan workout process

1. Goal is to maximize full recovery of funds
2. Rapid detection and reporting of problems is
essential
3. Loan workout should be separate from lending
function
4. Should consult with customer quickly on possible
options
5. Estimate resources available to collect on loan
6. Conduct tax and litigation search
7. Evaluate quality and competence of management
8. Consider all reasonable alternatives
 Questions & Problems

1. Why is lending so closely regulated by authorities?

2. What sources of information are available today that loan
officers and credit analysts can use in evaluating a
customer loan application?
3. What is loan review? How should a loan review be
conducted?
4. What are some warning signs to management that a
problem loan may be developing?
5. Problem 3, 4 and 5 (page 540-1)
 Answers
1. Why is lending so closely regulated by authorities?
 Lending is the center of risk for most lending institutions.
 In the U.S. banks are limited
 in the loans to a single borrower by the size of capital and surplus
 Limited real estate loans based on the size of total time and savings
deposits or capital.
 Discrimination against borrowers on the basis of their age, sex,
religion, or national origin is prohibited by U.S. law.
 Banks cannot discriminate against borrowers from certain
neighborhoods in their service areas.
 Any loans made are subject to examination and review and many
are restricted or even prohibited by law.
 How about lending institutions in Vietnam?
 Answers

2. What sources of information are available today that loan

officers and credit analysts can use in evaluating a
customer loan application?
 financial statements supplied by the borrower
 Field visits to the borrower’s business location
 industry-wide performance ratios for comparison purposes
supplied by such organizations as Dun and Bradstreet
 credit information exchange among business lending
institutions
 conferences and educational materials to help train loan
officers and credit analysts.
 Public media and internet
 Answers

3. What is loan review? How should a loan review be

conducted?
 Loan review is a process of periodic investigation of
outstanding loans on an institution's books to make sure
each loan is paying out as planned, all necessary
documentation is present, and the bank's loan officers are
following the institution's loan policy.
 While lending institutions today use a variety of different
loan review procedures, a few general procedures are
followed by nearly all lending institutions.
 Answers
3. What is loan review? How should a loan review be
conducted?
General procedures are
 Carrying out reviews of all types of loans on a periodic basis.
 Structuring the loan review process carefully to make sure
the most important features of each loan are checked.
 Reviewing the largest loans most frequently.
 Conducting more frequent reviews of troubled loans.
 Accelerating the loan review schedule if the economy slows
down or if industries in which the bank has made a
substantial portion of its loans develop significant problems.
 Answers

3. What is loan review? How should a loan review be

conducted?
 Loan review is a necessity for a sound lending program. It
 helps management to spot problem loans more quickly
 acts as a continuing check on whether loan officers are
adhering to a bank's loan policy.
→ to promote objectivity in the loan review process, loan
review officers are separated from the loan department
 Loan reviews also aid senior management and the bank's
board of directors in assessing
 the overall exposure to risk
 the possible need for more capital in the future.
 Answers

4. What are some warning signs to management that a

problem loan may be developing?
Problem loans are often characterized by:
 reduced communication between borrower and lender
 delays in receiving financial reports
 evidence of reevaluations of assets (such as inventory or
pension-plan assets)
 declining stock prices
 changes in management
 restructuring of other loans the borrower has taken out.
 Answers
5. Problem 3 (page 540-1)
These figures suggest that the minimum size credit line
available would be:
Minimum-Size Credit Line Available
= 0.30 x $25,000,000 + 0.40 x $12,650,000
= $7,500,000 + $5,060,000
= $12,560,000
 
Maximum-Size Credit Line Available
= 0.80 x $25,000,000 + 0.90 x $12,650,000
= $20,000,000 + $11,385,000
= $31,385,000
 Answers

5. Problem 4 (page 540-1)

The particular C of credit represented by each piece of
information presented in this problem was as follows:
a. First National Bank discovers there is already a lien against
the fixed assets of one of its customers asking for a loan
→ Collateral
b. Xron Corporation has asked for a type of loan its lender
normally refuses to make → Control
c. John Selman has an excellent credit rating → Character
d. Smithe Manufacturing Company has achieved higher
earnings each year for the past six years → Cash
 Answers

5. Problem 4 (page 540-1)

e. Consumers Savings Association’s auto loan officer asks a
prospective customer, Harold Ikels, for his driver’s license.
→ Capacity
f. Merchants Center National Bank is concerned about
extending a loan for another year to Corrin Motors
because a recession is predicted in the economy.
→ Conditions
g. Wes Velman needs an immediate cash loan and has
gotten his brother, Charles, to volunteer to cosign the note
should the loan be approved.
→ Character
 Answers
5. Problem 4 (page 540-1)
h. ABC Finance Company checks out Mary Earl’s estimate of
her monthly take home pay with Mary’s employer, Bryan
Sims Doors and Windows.
→ Cash
i. Hillsoro Bank and Trust would like to make a loan to Pen-Tab
Oil and Gas Company but fears a long-term decline in oil
and gas prices.
→ Conditions
j. First State Bank of Jackson seeks the opinion of an expert on
the economic outlook in Mexico before granting a loan to a
Mexican manufacturer of auto parts.
→ Control
 Answers

5. Problem 4 (page 540-1)

k. The history of Membres Manufacture and Distributing
Company indicates the firm has been through several
recent changes of ownership and there has been a
substantial shift in its principal suppliers and customers in
recent years.
→ Capacity
 
l. Home and Office Savings Bank has decided to review the
insurance coverage maintained by its borrowing customer,
Plainsman Wholesale Distributors.
→ Collateral
 Answers

5. Problem 5 (page 540-1)

One Two Three Four
Current Month Months Months Months
Month Ago Ago Ago Ago
Cash account ($mil) 33 57 51 44 43
Projected sales ($mil) 298 295 294 291 288
Share price (monthly avg) 6,60 6,50 6,40 6,25 6,50
Capital structure (E/D) (%) 32,8 33,9 34,6 34,9 35,7
Liquidity ratio (current assets/
current liabilities) 1.10x 1.23x 1.35x 1.39x 1.25x
EBIT ($mil) 15 14 13 11 13
ROA (%) 3,32 3,25 2,98 3,13 3,11
Sales revenue ($mil) 290 289 290 289 287
 Answers
5. Problem 5 (page 540-1)
Selected items reported to the bank by the company do indicate
the possible development of a problem loan situation, such as:
 cash account has fallen sharply in the latest month after
several months of a substantial uptrend
 liquidity ratio of current assets to current liabilities has declined
significantly in the last 3 months, which may be signaling
declining sales and/or difficulty in maintaining enough cash to
meet near-term liabilities.
 ratio of equity capital relative to debt financing is falling,
indicating that creditors (including Citicenter Bank) are
providing a larger share of the firm's capitalization → each
creditor is becoming less well secured.
 Answers
5. Problem 5 (page 540-1)
 Perhaps of greater moment is the decline of sales revenue
below Butell's projections. As of the latest month sales
revenue reached $290 million versus a projection of $298
million → Citicenter Bank must determine the causes of
this sales shortfall to see if the firm is encountering
increasing resistance to sales of its product lines.
 However, even this trend may not be cause for alarm
because sales may be so volatile in Butell's industry that
few analysts put any faith in sales projections → The
bank's loan officer needs to review the customer's earlier
sales projections and sales revenue to determine if there is
a real cause for concern.
 Answers

5. Problem 5 (page 540-1)

However, these changes in liquidity and capital structure

may only reflect normal seasonal pressures and may not
be real problems for the bank, especially because other
aspects of Butell's recent performance - its stock price,
earnings before interest and taxes, and ROA seem to be
improving.
 Answers

5. Problem 5 (page 540-1)

Butell has indicated a recent switch in inventory and

depreciation accounting methods.

→ Citicenter's loan officer would do well to inquire into

the reasons for these changes because they may reflect
an attempt by the firm to offset actual or potential
future losses in some aspect of its operations.
 CREDIT POLICIES AND
PROCEDURES: MANAGING
CREDIT RISK

Chapter 5

William Chittenden edited and updated the PowerPoint slides for this edition.