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Prepared by John Anderson, Queensland University of Technology

Prepared by John Anderson, Queensland University of Technology. Chapter One. The Principles of Lending and Lending Basics. Learning Objectives. Identify the basic principles governing bank lending and explain their importance.

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Prepared by John Anderson, Queensland University of Technology

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  1. Prepared by John Anderson, Queensland University of Technology

  2. Chapter One The Principles of Lending and Lending Basics

  3. 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.

  4. 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.

  5. Learning Objectives • Explain the importance of credit culture in a lending institution. • Understand how an advances portfolio is designed.

  6. 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.

  7. 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.

  8. 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.

  9. Principles of Good Lending • Traditional Methods of Credit Analysis — the “Five Cs”: • Character • Capacity • Capital • Collateral • Conditions

  10. Principles of Good Lending • Modern Approaches to Credit Risk Measurement: • Econometric techniques • Optimisation models • Neural networks • Hybrid systems

  11. 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

  12. 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

  13. 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

  14. 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

  15. 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.

  16. 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

  17. 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.

  18. 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

  19. 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

  20. 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

  21. 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

  22. 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

  23. 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)

  24. 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

  25. 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?

  26. 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.

  27. Asset Quality • Criticized Loans • Scheduled Loans • Adversely Classified • 1. Substandard loans • 2. Doubtful loans • 3. Loss loans • Examiners compare the weighted averages of adversely classified loans with the bank’s sum of loan loss reserves and equity capital. • (.20) Substandard loans + (.50) Doubtful loans + • (1.0) Loss loans = grand total

  28. Parts of a Typical Loan Agreement • The loan is given with a written contract that has several parts. • The Note: It is signed by the borrower and it specifies the principal amount, interest rate, and the term of repayment. • 2. Loan Commitment Agreement: This is done for large loans and home mortgage loans. Bank promises to make credit available to the borrower over a certain period. • 3. Collateral: Bank loans may be either secured or unsecured.

  29. Parts of a Typical Loan Agreement (cont.) • 4. Covenants: Most formal loan agreements contain restrictive covenants, which are usually one of two types: • affirmative, or • Negative • Affirmative Covenants: Require the borrower to take certain actions, such as periodically filing financial statements with the bank, maintaining insurance coverage on the loan and on any collateral pledged. • Negative Covenants: Restrict the borrower from doing certain things without the bank’s approval, such as taking on new debt, acquiring additional fixed assets, participating mergers, and selling assets.

  30. Parts of a Typical Loan Agreement (cont.) 5. Borrower Guaranties or Warranties: Theborrower guarantees or warranties that the information supplied in the loan application is true and correct. 6. Events of Default: most loans contain a section listing events of default, specifying what actions or inactions by the borrower would represent a significant violation of the terms of the loan agreement, and what actions the bank is legally take in order to secure its funds.

  31. Warning Signs of Problem Loans • Unusual or Unexpected Delays in Receiving Financial Statements • Changes in Accounting Methods • Restructuring Debt or Eliminating Dividend Payments or Changes in Credit Rating • Adverse Changes in Price of Stock • Net Earnings Losses in One or More Years • Adverse Changes in Capital Structure • Deviations in Actual from Predicted Sales Amounts • Unexpected or Unexplained Changes in Deposit Balances

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