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Chapter 4. How To Construct A Lending Proposition
Chapter 4. How To Construct A Lending Proposition
HOW TO CONSTRUCT
A LENDING
PROPOSITION
By
Nguyen Thi My Hanh
HOCHIMINH UNIVERSITY OF BANKING
LEARNING OBJECTIVES
By the end of this chapter, you will be able to:
• Apply the principle of credit risk to commercial businesses as part of the
lending process and as a key component of bank credit policy;
• Apply risk mitigation techniques in the lending process;
• Identify and apply the separate elements that are required to
successfully create a lending proposition;
• Identify the main sources of information required to assess commercial
lending propositions;
• Explain the importance of face-to-face customer meetings (internal and
external); and
• Identify and apply covenant setting in bank/customer lending agreements.
HOCHIMINH UNIVERSITY OF BANKING
CREDIT RISK
Credit risk is one of the main risks facing banks when they lend money. It is
the risk that customers who have been lent money fail to repay some or all of
the funds they have borrowed. This may ultimately leave the bank with
impairments and bad debts and will mean that the bank may have to write off
monies they have lent.
HOCHIMINH UNIVERSITY OF BANKING
CREDIT POLICY
• Any bank, as an integral part of its lending processes, will have a credit
policy which will cover all lending to the commercial counterparties it
normally deals with.
• Credit policy is a formal set of rules adopted by a bank or financial
institution which set out the circumstances under which it should lend to
businesses.
• The purpose of a credit policy is to set out the appetite a bank has towards
credit risk, how it may be mitigated (for example, security to be taken and
the discount factors to be used) and will also focus on particular sectors and
industries (see below). One of the principal purposes is to give staff who are
actively engaged with lending to commercial customers specific guidelines
to allow them to lend effectively.
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SECTOR APPETITE
• Banks will face lending requests from a variety of sectors and it is important
that a bank can articulate its specific appetite to a sector at any time; this is
known as the sector appetite. Real estate (property), for example, is an
important part of a bank’s commercial lending book and the bank needs to
be clear about the types of customer it will support and under what
circumstances.
• Sector appetite The level of willingness that a bank has to lend to a specific
industrial sector.
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SECTOR APPETITE
• For investment real estate the bank may only wish to lend up to 60 per cent
loan to value, for a maximum of five years, with a concentration risk of less
than 30 per cent to any one counterparty (for example, no one tenant is to be
more than 30 per cent of the overall annual rental income). Any proposition
put forward that is outside those parameters will need very solid
justifications as to why it should be supported including mitigants that might
be used (for example, extra security offered by the directors, including
personal guarantees).
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LENDING PROPOSITION
SANCTIONING PROCESS
Sanctioning process is the internal processes a bank goes through when
agreeing to lend money, particularly to a commercial business. This will
usually involve having a separate credit department as part of this process.
All banks operate a sanctioning process which requires a relationship manager
to put together a lending proposal that encompasses all the elements that we
are exploring in this chapter. The lending proposal includes a recommendation
to lend the monies and on what terms. This will then be submitted to a credit
department who will agree (or decline) the proposal.
HOCHIMINH UNIVERSITY OF BANKING
SANCTIONING PROCESS
The proposition may not be agreed on the exact terms that have been proposed
and there may be a number of discussions that take place between the credit
department and the relationship manager before the final agreement. This may
entail further discussions with the customer and may require the customer to
inject further cash into the deal, or provide further security.
Terms may also be amended from the original proposal (for example, the term
of a loan could be reduced).
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SANCTIONING PROCESS
Once a deal is agreed, the relationship manager will be responsible for issuing
facility documentation that reflects the agreed terms and will also be
responsible for ensuring that any security which is part of the deal has been
taken prior to the lending of the monies. Regular monitoring reports will also
be required to the credit department to ensure that all agreed terms and
conditions are being complied with (for example, covenants).
Facility is a specific line of credit provided to commercial customers (eg.
overdraft/loan, etc )
HOCHIMINH UNIVERSITY OF BANKING
SANCTIONING PROCESS
All banks have lending systems which capture all the details of each
individual customer that they lend to. This should incorporate everything that
the bank knows about the customer at the current time and it is obviously
important that any changes in the business (such as expanding the number of
outlets a retail business has) are recorded as soon as possible. Whilst each
bank will have a unique system, they will all have similarities.
The initial information that a banker will be interested in on a day-to-day basis
is what ‘facilities’ a customer has and what the current exposure is for each
facility. This is likely to be on the front page of any customer’s details.
Exposure is the level of lending to a business.
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The key consideration here is that many risks will be experienced by the
customer and the role of the banker is to assess how each risk, if and when it
manifests itself, will impact on the business and whether this will then impact
ultimately on the ability of the business to repay the borrowing.
Ability is The specific capabilities of a business to carry out its core activities
and therefore be able to repay its borrowing.
HOCHIMINH UNIVERSITY OF BANKING
CASE STUDY
CASE STUDY
One year ago, they took out a loan of £30,000 (on a five-year term) to spend on
new computer equipment and to refurbish the office space, adding a small area
for client presentations.
Consider the following scenario: Becky is knocked off her bike one morning
coming into work and dies in hospital later that day. Sundira, her friend and
business partner, now has to deal with not only the grief of losing Becky, but
also running the business on her own.
The relationship manager at the bank insisted when the new loan was taken out
that Becky and Sundira take out an insurance policy called a key person
protection policy for the full amount of the loan (£30,000). This is a business
life policy, and in this case would be on the lives of Becky and Sundira, paying
out against the death of one of the partners. The bank took an assignment over
the policy.
HOCHIMINH UNIVERSITY OF BANKING
CASE STUDY
Consider the issues that Sundira will now be faced with and how this will
impact on the bank. Why will the key person protection policy be useful for
Sundira and the bank?
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There are several lending mnemonics that can be used to analyze and assess a
lending request. These include PPARTSI and CAMPARI. There is no one
mnemonic which is better than another and they are, in essence, a way of
ensuring that all of the key elements are considered and assessed when
analyzing a lending proposition.
HOCHIMINH UNIVERSITY OF BANKING
PPARTSI
● Person (who willingness to pay, good historical payment
● Purpose
● Amount (appropriate the amount of money the borrower need)
● Repayment
● Term
● Security
● Income
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CAMPARI
● Character
● Ability
● Margin
● Purpose
● Amount
● Repayment
● Insurance (security)
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Customers often don’t know exactly how much they need (particularly new
businesses) and many customers are nervous about asking the bank for too
much in case they (the bank) decline the request.
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EXAMPLE
The usual prudent ‘rule of thumb’ is to add a 10 per cent contingency to the overall
costings that are provided by the developer. Residential developments (houses or flats)
will typically be over a relatively long period, certainly more than a year (depending on
how many properties are being constructed) and will be subject to a number of issues
that will be outside the control of the customer (and the bank!). This will include the
weather (a harsh winter will mean that work will slow down or stop for a period), the
increase in raw material costs, the insolvency of a key contractor (a new contractor will
need to be found and this again will slow down the work) or discovering issues when the
foundations are being prepared for the development (often this is where many of the
‘hidden’ costs are in a development).
All of these potential issues will slow down the particular development and will create
higher costs for the development. If the developer does not have the funds for
contingencies, then inevitably there will be an approach to the bank to lend more money.
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EXAMPLE
The major credit risk for the bank, related to this type of customer, is that once work
has commenced, the only source of repayment is from the sale of completed houses. If
the developer doesn’t complete the houses then the only course of action will be for the
bank to lend further funds to ensure the houses are completed, or, in more extreme
circumstances, to take control of the development, and pay for another developer to
finish the work. In both instances, the lending exposure of the bank increases beyond
the limit of what was initially agreed and there will potentially be a much narrower gap
between the sale prices of the new properties and the funds borrowed. The smaller the
gap, the bigger the risk that the bank will not be fully repaid from the sale of the
completed properties.
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Bankers need to use their expertise and experience to guide customers when
dealing with new lending requests. This involves assessing the proposition very
carefully to ensure that the customer is borrowing enough for their short and
medium-term requirements.
A lack of experience (on the customer’s behalf) doesn’t mean that a customer will
be a ‘bad’ customer and not repay but it does mean that the banker needs to
compensate for this by thinking for the customer and challenge the business
proposition in a constructive manner.
HOCHIMINH UNIVERSITY OF BANKING
This is a very wide-ranging topic and with the extensive range of businesses
and sectors that a banker is likely to deal with on a regular basis, it is very
important that there is a framework that can be used to analyze some of the
internal and external factors. It is important to split this into external and
internal considerations.
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EXTERNAL CONSIDERATIONS
PESTLE
It is a tool used to examine the external factors that can impact on the
environment a business operates in. It groups all the external factors together
under a number of key headings:
● political;
● economic;
● social;
● technological;
● legal; and
● environmental.
HOCHIMINH UNIVERSITY OF BANKING
ABILITY TO REPAY
The ability of a business to repay its borrowing is based on the profits it can
generate, both now and in the future. The initial analysis will revolve around
current performance (usually the full accounts from the past 12 months) and
current performance using up-to-date management information and trading or
cash flow forecasts. If the lending proposition is for an increase in borrowing,
then the prudent approach by the bank is usually to calculate if the business
can afford to pay the increased borrowings back from current profitability
rather than projected profitability. If it can, then there is a strong argument for
supporting the new borrowing.
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ABILITY TO REPAY
• If the business can’t, the projections need to be examined very carefully, and
if they show a significant increase in both turnover and profitability, they
need to have sensitivities applied to them to show an increase in turnover
and profitability which is more reflective of performance in the last few
years. This can then be used to assess the request for the new borrowing.
HOCHIMINH UNIVERSITY OF BANKING
INTEREST RATES
• A major risk to both customers and their bankers, which impacts on the
ability to repay and also links directly to credit risk, is that of rising interest
rates.
• Many commercial customers often borrow at ‘floating rates’, which means
that the agreement between the customer and the bank will be worded in
such a way that the customer will borrow at a rate (or margin) above base
rate. This margin will be for the term of the loan or overdraft and will
remain at the same rate throughout the life of the loan.
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INTEREST RATES
• For example, at a margin of 3 per cent above base and a base rate of 0.5 per
cent, the full rate paid by the customer is 3.5 per cent. However, what
remains a variable is that base rate can alter, up or down, through the life of
the loan. If the central bank decides to raise interest rates (to control
inflation, for example) then the customer has no option but to pay the
increased costs on their loan. This could be for the rest of the term of the
loan. Banks will therefore often model serviceability against a
predetermined ‘default rate’ to give a through the cycle view of
serviceability.
HOCHIMINH UNIVERSITY OF BANKING
INTEREST RATES
• A small rise in base rate may not appear on the face of it to be too onerous;
however, it needs to be put in context with each customer. For every £1
million borrowed by a commercial customer, a rise in base rate of 0.5 per
cent creates an extra £5,000 per annum in interest costs. The immediate
impact of any rise in interest rates is a reduction in profits and also an
impact on the cash position of the business. Most loans have interest applied
on a quarterly basis and therefore it is likely that the bank will very quickly
increase the monthly or quarterly repayments following an increase in base
rate to ensure that the loan is repaid within the original term.
HOCHIMINH UNIVERSITY OF BANKING
SECURITY
• This should always come towards the end of any lending proposition
analysis. This is because the lending proposition should be one the bank
wants to support before it considers what security it can take. All the risks
facing the business, both internal and external, need to have been identified,
considered and analyzed before security is considered.
• Commercial lending is usually undertaken on the basis that the bank has
sufficient security to cover it if the customer cannot repay the borrowing.
The security can be liquidated (turned into cash) and the borrowing repaid.
HOCHIMINH UNIVERSITY OF BANKING
SECURITY
• There is often a widely held belief by bankers that if they are ‘fully secured’
on a ‘written-down’ basis that they will not lose money if a business fails.
This is simply not true, although if security is held there is a much better
chance that the bank will get its money back if the business runs into severe
financial difficulties.
HOCHIMINH UNIVERSITY OF BANKING
SECURITY
The guiding principle is that banks should not lend 100 per cent against any
asset value that it has as security. There are a number of reasons for this and
the main arguments against lending fully against an asset include:
• Time – it takes time to sell an asset;
• Costs – there will usually be professional costs such as valuations, agents’
fees and solicitor fees;
• Interest costs – these will continue to be incurred during the period it takes
to sell an asset; and
• Potential deterioration in the value of the asset.
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COVENANTS
Within its lending documentation the bank is likely to have certain terms and
conditions often known as covenants. Covenants are specific clauses built
into loan agreements that provide the ability of the bank to monitor the
performance of a business after monies have been lent.
Sometimes the terms and conditions are ones which the bank wants to have in
place before the borrowing takes place, and these are known as conditions
precedent.
Conditions precedent are often very straightforward terms such as:
• All security being in place before the funds are lent; or
• Professional valuations conducted (and addressed to the bank) before the
funds are lent.
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SOURCES OF INFORMATION
• The business plan
• Trade receivables/trade payables
• Desk-top research
• Customer visits
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BUSINESS PLAN
• If a customer has never produced a business plan then you, as the banker,
might need to guide them so that they produce the information that you
need.
To recap, the areas are as follows:
• Borrowing – the amount and why customers borrow;
• Assessing the business – internally/externally/USPs/strategy;
• Management and staff;
• Product;
• Ability to repay;
• Security; and
• Covenants.
HOCHIMINH UNIVERSITY OF BANKING
BUSINESS PLAN
• There is a tendency amongst less experienced customers to feel that the
business plan is only for the bank and its only purpose is to get the bank to
agree to lend money. This is rather missing the point and you can help
customers by asking them to articulate why they feel their business venture
will succeed. It is a very positive way of letting them explore all the
elements of the business; strategically, operationally and financially.
• The business plan should show what the aims and objectives are of the
business, the strengths of the management team, and the product or service
that the business is producing or providing. It should also cover the key risks
faced by the business and how these will be addressed.
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BUSINESS PLAN
• The banker will use this as a starting point for a detailed analysis of the new
proposition and by using a structure that has already been described, the
banker can focus on the key areas and build a strong picture of how the
business will achieve its aims, and importantly how it will repay the funds it
is requesting from the bank.
HOCHIMINH UNIVERSITY OF BANKING
DESK-TOP RESEARCH
The business plan is a good starting point for the bank and it should be
supplemented with other research such as desk-top research. Most customers
have websites and these provide a good source of information about the
company and its products. Brochures and catalogues are always useful,
especially if the customer produces a range of technical products.
Reviewing websites and other material not only gives further information to
the banker, but it also gives an objective view of how a customer might
engage with the business.
HOCHIMINH UNIVERSITY OF BANKING
DESK-TOP RESEARCH
As a banker you need to understand who the competitors are to your
customer’s business and a review of the competitors’ websites will be a useful
way of comparing the products and services in the marketplace.
Other good sources of information are local magazines, local newspaper
articles or business newspaper websites. These often have articles about how a
business is bringing out a new product or how it is engaging with the local
community.
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CUSTOMER VISITS
• Desktop research on a business is always very valuable and any customer
expects a banker to have done their ‘homework’ and know about the sector
that the customer operates in. However, there is no substitute for spending
time with a customer at their premises. Going to visit a business without the
customer is much easier if the business is in retail or leisure but much less
easy if the customer is a manufacturer. However, if you can arrange visits to
factories or industrial sites they can offer you invaluable insight into how a
customer operates. By walking around a site you would gain a clear view of
what it looks like as well as be able to assess the upkeep and maintenance of
buildings and machines.
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MAKE DECISIONS!
When you’ve taken all of the above into consideration, you need to decide:
does the deal make sense?
This is not an easy question to answer and requires a detailed analysis of the
business and the management using the techniques discussed above. Is there a
market for the product or service? If the business is heading in a new
direction, do they have the skills within the management team to achieve their
new goals?
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MAKE DECISIONS!
• Part of the decision may involve a level of ‘gut-feel’ decision making. You
will need to trust the customer (and in turn the customer will need to trust
you). This is not something that will be in a business plan!
• After all the information that a banker has they have to make a decision
about whether or not they want to lend to the customer. They need to make a
recommendation to their credit department and put forward the specific
terms they wish to lend on.
EXERCISE HOCHIMINH UNIVERSITY OF BANKING
ABC Enterprises Ltd, a family business set up by Bonny and her husband Max, imports millinery materials from all
over the world. It was established 10 years ago and has a significant need for increased warehousing space. The
directors are looking to buy new premises, in the company name, outside of Peterborough for £3 million. They have
cash of £750,000 that has been built up as a cash purchase and want to borrow the balance from their bank. A new loan
of £2.25 million in the name of the limited company will only be the legal liability of the company and the directors
will have no personal liability for the loan.
Further information: The business currently rents its existing premises but has outgrown them. The present five-year
lease is due for renewal in 12 months’ time (lease payments are £125,000 per annum). The new premises are purpose-
built.
• The directors have calculated they will need to make repayments of £150,000 per annum on the new loan.
• You are required to examine how a bank might decide how much it should lend. Your lending proposal will be:
+ Using the lending structure PPARTSI, consider the above lending proposition.
+ What other questions will the bank want to ask the customer about this transaction?