Prepared by John Anderson,

Queensland University of Technology

 Chapter One

The Principles of Lending and

Lending Basics

2
 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.

3
 Learning Objectives

• Explain the characteristics of various

types of bank advance.
• Distinguish different types of
borrowers and any special
considerations in lending.
• Explain how advances are
structured.

4
 Learning Objectives

• Explain the importance of credit

culture in a lending institution.
• Understand how an advances
portfolio is designed.

5
 Introduction

• Lending evolved in real-world

practice with supporting principles
developed later.
• Lending principles are universal in
their application to loans of all sizes.
• Lending is both an art and a science.

6
 Principles of Good Lending

• Safety of Loan:
– Borrower should be of good character,
financially sound with the ability and
willingness to repay the loan.
• Suitability of Loan Purpose:
– Loan applications may be accepted or
rejected subject to bank policy, legality
and ethical principles.
7
 Principles of Good Lending

• Profitability:
– The risks and returns from lending
activities must be carefully considered to
improve viability of loan portfolio.
• Following the Lending Principles:
– Regardless of loan size, lending
principles of varying levels of
sophistication must be rigorously
adhered to.
8
 Principles of Good Lending

• Traditional Methods of Credit

Analysis — the “Five Cs”:
– Character
– Capacity
– Capital
– Collateral
– Conditions

9
 Principles of Good Lending

• Modern Approaches to Credit

Risk Measurement:
– Econometric techniques
– Optimisation models
– Neural networks
– Hybrid systems

10
 A Framework For Credit and
Lending Decisions

• External Factors Affecting

Lending Decisions:
– Legislation including common law, RBA
Act, Banking Act, Uniform Consumer
Credit Code, ASIC Act and the ACCCs
consumer laws
– Macroeconomic factors
– Industry-specific factors

11
 A Framework For Credit and
Lending Decisions

• Lending Institution-Specific
Factors:
– Institution's lending policy, Loan
Budget and Staff Availability
• Borrower-Specific Factors:
– Meeting “Five Cs” requirements and
compliance with legal requirements
such as common and ‘black-letter’ law
12
 The Lending Process

• Ten-Step Process:
– Step 1: Use of prescribed application
form
– Step 2: Obtain required supporting
documents such as income and/or
financial statements
– Step 3: Check loan application and
supporting documents for
inconsistencies

13
 The Lending Process

– Step 4: If personal loan, loan decision

can be made. If business loan, lender
to gain better knowledge of proposed
borrower’s business
– Step 5: Appraise technical,
commercial, financial and managerial
aspects of the business
– Step 6: Assess financial requirements
and determine most suitable product
14
 The Lending Process

– Step 7: Advise potential borrower

whether loan application is successful
or not
– Step 8: Ensure security and all other
loan documents are signed
– Step 9: Monitor borrower’s financial
position and repayment position
– Step 10: Ensure necessary steps are
taken before loan in default.

15
 Characteristics of Different
Types of Advance

• Traditional Types of Advance

– Loans Classified According to:
• Security — secured v. unsecured loans
• Type of Borrower — personal, business
or government
• Term of Loan — short, medium or long
• Sector — retail, manufacturing or
mining

16
 Characteristics of Different
Types of Advance

• Traditional Types of Advance

– Loans Classified According to:
• Region — rural, town or major city
• Purpose — personal, home,
commercial, motor vehicles.
– Overdrafts:
• Flexible form of fixed limit continuous
loan with no fixed repayment schedule
and flexible drawdown characteristics.
17
 Characteristics of Different
Types of Advance

• Modern Forms of Advance for

Business:
– Equity Participation: where equity
rather than debt finance is provided
– Loan Syndication: consortium of
lenders provide funding
– Equipment Leasing: financing v.
operating
– Factoring: sale of business’ debt
18
 Different Types of Borrower

• Personal:
– Unable to enter loan contract if:
• Minors — borrower under 18 years
• Persons of unsound mind
• Insolvents — bankrupts or insolvents who
are either undischarged or pending
proceedings
– Joint Accounts: account held in the name
of two or more persons
– Husband and Wife: see joint account
19
 Different Types of Borrower

• Business Borrowers:
– Sole Proprietorship: Business operated
by one person
– Partnerships: Business with more than
one owner where profits shared
– Companies: Separate legal entity
recognised under Corporation Law

20
 Different Types of Borrower

• Special Types of Borrower:

– Local authorities: e.g. local government
entities such as City Councils
– Clubs, Literary Societies and Schools:
Generally registered as unincorporated
associations or trusts
– Unincorporated Associations: e.g. arts,
charities and religious organisations
– Co-operatives: e.g. farming bodies

21
 Structuring of Advances

• Security/Collateral:
– Includes land, buildings, directors’
guarantees, shares and crop liens
• Debt Covenants:
– Outlines key loan conditions including
fees, security, repayments
• Pricing Issues:
– Risk premium over a benchmark rate

22
 Credit Culture

• Can be defined as:

– The institutional priorities, traditions
and philosophies that surround credit
or lending decisions; and/or
– “The collection of principles, actions,
deterrents and rewards that exist within
a lending organisation” Caouette, Altman and
Narayanan (1998)

23
 Credit Culture

• Banc One uses the principles of:

• Strong customer orientation
• A preference for small exposures
• An understanding of the business to whom
you are lending
• Understanding of the organisation’s risk
tolerance and profit goals when assessing
proposals
• Understanding that avoidance of problem
loans is not necessarily a good sign

24
 Designing an Advances
Portfolio

• Advances portfolio design requires

decisions incorporating:
• What resources are available to invest?
• Of these, what proportion should be
invested in advances?
• What proportions should be invested in
personal versus business advances?
• Of those personal advances, what
proportion should be in housing loans,
credit cards and so on?

25
 Designing an Advances
Portfolio

• Three main approaches:

– Historical or recent loss experience
– Standards based on risk tolerance to
capital
– Risk-adjusted return on capital, where
risk is evaluated relative to the risk
either at the transaction level or
business unit level.

26
27