BANKS LENDING: POLICIES & PROCEDURE

1. BANKS LENDING: POLICIES & PROCEDURE Reference: Peter S. ROSE

2. Why Credit Management: Making loans is the principal economic function of banks. For most banks, loans account for half or more of their total assets and about half to two-thirds of their revenues. Risk in banking tends to be concentrated in the loan portfolio. Uncollectable loans can cause serious financial problems for banks.

3. Loan Vs Advance • Many people think that loan and advance is almost same . Both means when a person borrows the money from other , it is called loan or advance . Both Loan and Advance are to be repaid in installments for example: monthly installments of equal amounts. But , In true sense, it has many differences. • loan is against a security but advance is not against any security but based on relationship, for example vehicle loan given to employees is against the security of the vehicle and if advance is given for travel then it is not against any security • There is a sense of debt in loan, whereas an advance is a facility being availed of by the borrower.

4. Banks grant advances largely for short-term purposes, such as purchase of goods traded in and meeting other short-term trading liabilities. But loan could be for any period. • Interest terms and structure is different. • Example: Advance: Consumer loan(Car, Refrigerator), Personal loan, Staff loan, Loan against FDR. a. Advances to allied concerns of Directors b. Advances to Chief Executive c. Advances to Other Senior Executives d. Advances to Customer's Group: Agriculture loan Commercial lending Export financing Consumer credit scheme Special Program Loan (SME) Staff loan Source: Annual repot-2009, Dhaka Bank Ltd. Page: 98

5. Types of Loans Made By Banks: Bank loans can be grouped according to their purpose. 1. Real Estate Loans: secured by real property (land ,building, and other properties).can be both short term (land development & construction) long term ( for purchase of farmland, homes, apartments, commercial structures) 2. Financial Institution Loans: credit to banks, insurance company, finance company and other FI 3. Agricultural Loans: planting and harvesting crops and to support feeding and care of livestock

6. 4. Commercial and Industrial Loans: Purchasing inventories, paying tax, meeting payrolls, factory infrastructure • 5. Loans to Individuals: consumer loan, auto mobile, home loan, medical expense, other personal expenses • 6. Miscellaneous Loans: Securities loan, other loan which is not categories here including • 7. Lease Financing Receivables: buy equipment/ vehicle and lease them

7. Table 16.1 Loans Outstanding for US Banks

8. Factors Determining the Growth and Mix of Bank Loans: • Characteristics of Market Area Served: sub urban surrounded by household , central city surrounded by office • Size of the Bank: large-Wholesales credit, small-retail credit • Experience and Expertise of Management • Expected Yield of Each Type of Loan: credit card loan, installment loan(household and SME loan),real estate loan. • Regulations: from govt. and central bank

9. Regulation of Lending • The loan portfolio of any bank is influenced by regulation. For example, in the USA, real estate loans cannot exceed the banks capital, or 70% of its total time and savings deposits. Also, a loan to a single customer cannot exceed 15 % of banks capital. • Asset Quality • Maintain ace of Provision • Eligible Securities • Determination of Security Value

10. i) Asset Quality • Criticized Loans: Loans that are performing well but have minor weaknesses because the bank has not followed its own loan policy or has failed to get full documentation from the borrower are called criticized loans • Unclassified • Special Mention account • Scheduled Loans: Loans that appear to Contain significant weaknesses or that represent what the examiner regards as the dangerous concentration of credit in one borrower or in one industry are called scheduled loans. A scheduled loan is a warning to a bank’s management to monitor that credit carefully and to work toward reducing the bank’s concentrated risk exposure from it

11. Scheduled/Classification of Loan When an examiner finds some loans that carry an immediate risk of not paying out as planned, these credits are adversely classified. • Sub-standard: • Doubtful • Bad debt/ loan losses

12. Sub-standard: where the bank’s margin of protection is inadequate due to weaknesses in collateral or in the borrower’s repayment abilities; if it remains past due/overdue for 6 months or beyond but less than 9 months Doubtful: which carry a strong Probability of an uncollectible loss to the bank; if it remains past due/overdue for 9 months or beyond but less than 12 months Bad debt/ loan losses which are regarded as uncollectible and not suitable to be called bankable assets. it remains past due/overdue for 12months or beyond.

13. ii) Maintenance of Provision • a) (i) Banks will be required to maintain General Provision in the following way : (1) @ 1% against all unclassified loans (other than loans under Small Enterprise and Consumer Financing and Special Mention Account.) (2) @ 2% on the unclassified amount for Small Enterprise Financing. (3) @ 5% on the unclassified amount for Consumer Financing whereas it has to be maintained @ 2% on the unclassified amount for (i) Housing Finance and (ii) Loans for Professionals to set up business under Consumer Financing Scheme. (4) @ 5% on the outstanding amount of loans kept in the 'Special Mention Account' after netting off the amount of Interest Suspense. (Source: BRPD Circular No. 16 , effective from January 01.1999.)

14. Maintenance of Provision • b) (i) Banks will maintain provision at the following rates in respect of classified (Continuous, Demand and Fixed Term) Loans:(1) Sub-standard 20% (2) Doubtful 50% (3) Bad/Loss 100%(ii) Provision in respect of Short-term Agricultural and Micro-Credits is to be maintained at the following rates: (1) All credits except 'Bad/Loss'(i.e. 'Doubtful', 'Sub-standard', irregular and regular credit accounts) : 5%(2) 'Bad/Loss' : 100% (Source: BRPD Circular No. 16 , effective from January 01.1999.)

17. CAMELS Rating System • Capital adequacy • Asset quality • Management quality • Earnings record • Liquidity position • Sensitivity to market risk Banks whose overall CAMELS rating is toward the low, riskier end of the numerical scale ( and overall rating of 4 or 5 ) are examined more frequently than the highest rated banks, those with ratings of 1,2,or3.

18. Steps in the Lending Process • The customer fill out a loan application • An interview with a loan officer usually follows right away • If a business or mortgage loan is applied for, a site visit is usually made by an officer of the bank to assess the property • The customer is asked to submit several crucial documents, such as financial statements • The credit analysis division of the bank analyses the application and prepares a brief summary and recommendations. • Recommendation goes to the loan committee for approval • If the loan is approved, the loan officer check on the property that is pledged as collateral in order to ensure that the bank has immediate access to the collateral if the loan agreement is defaulted. This is often referred to as perfecting the bank’s claim to collateral.

19. Credit Analysis: The division of the bank responsible for analyzing and making recommendations about loanapplications is the credit department. Is the Borrower Creditworthy? This usually involves a detailed study of six aspects of the loan application: character, capacity, cash, Collateral, conditions, and control.

20. The Six Basic C’s of Lending 1. Character—Specific Purpose For Loan and Serious Intent to Repay Loan 2. Capacity—Customer Has Legal Authority to Sign Binding Contract 3. Cash—Does the Borrower Have the Ability to Generate Enough Cash to Repay the Loan 4. Collateral—Does the Borrower Have Adequate Assets to Support the Loan 5. Conditions—Must Look At the Industry and Changing Economic Conditions to Assess Ability to Repay 6. Control—Does Loan Meet Written Loan Policy and How Would Changing Laws and Regulations Affect Loan

21. Common Types of Collateral/Security • Accounts Receivable • Factoring • Inventory • Real Property-mortgage • Personal Property • Personal Guarantees

22. iii) Eligible Securities: • In the definition of 'Eligible Securities' as mentioned in the above paragraph the following securities will be included as eligible securities in determining base for provision: -100% of deposit under lien against the loan -100% of the value of government bond/savings certificate under lien. -100% of the value of guarantee given by Government or Bangladesh Bank (Source: BRPD Circular No. 16 , effective from January 01.1999.)

23. Eligible Securities contd.: -100% of the market value of gold or gold ornaments pledged with the bank. -50% of the market value of easily marketable commodities kept under control of the bank -Maximum 50% of the market value of land and building mortgaged with the bank -50% of the average market value for last 06 months or 50% of the face value, whichever is less, of the shares traded in stock exchange. (Source: BRPD Circular No. 16 , effective from January 01.1999.)

24. iv) Determination of Market Value of Eligible Securities • In determining market value of easily marketable commodities, land and building, banks are advised to follow the instructions mentioned below: (a) Easily marketable goods will mean pledged, easily en-cashable /saleable goods that remain under full control of the bank. However, while the concerned bank branch official will conduct periodic inspection to verify as to whether issues such as the suitability of goods for use, expiry period, appropriateness of documentary evidences, up to date insurance cover, same will have to be assessed by the professional assessor from time to time. (b) For land and building, banks will have to ensure whether title documents are in order and concerned land and building will have to be valued by the professional valuation firm along with completion of proper documentation in favor of the bank. In absence of professional valuation firm, certificate in favor of such valuation will have to be collected from the specialized engineer. Nevertheless, temporary houses including tin-shed structure shall not be shown as building.

25. Determination of Market Value of Eligible Securities contd… c) In order to facilitate the on-site inspection by our Department of Bank Inspection, banks are also advised to maintain complete statement of eligible securities on a separate sheet in the concerned loan file. Information such as description of eligible securities, their assessment by recognized firm, marketability of the commodity, control of the bank, and reasons for considering eligible securities etc. will have to be included in that sheet. In terms of the above policies, the banks will conduct their classification- activities on quarterly basis. Detailed statements in respect of classification, provision and 'Interest suspense‘ accounts will have to be submitted to Bangladesh Bank within 30 days from the reference date. (Source: BRPD Circular No. 16 , effective from January 01.1999.)

26. Loan Review (Loan Monitoring) • After the loan is granted, the loan department must periodically review all loans until they reach maturity. Loan review helps bank management to spot problem loans quickly. This increase the chance to recover the loans and reduce the bank losses.

27. 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

28. Topics for home work (Consult with the Referred Book, especially pages:528-531)

29. Under which of the six C’s of credit discussed in this chapter does each of the following pieces of information belong? • First national bank discovers there is already a lien against the fixed assets of one of its customers asking for a loan. • Xron Corporation has asked for a type of loan the bank normally refuse to make. • John Selman has an excellent credit rating. • Smithe Manufacturing Company has achieved higher earnings each year for the past six years. • Commerce National Bank is concerned about extending a loan for another year to Corrin Motors because a recession is predicted in the economy stating within the next quarter of the year.

30. Wes Velman needs an immediate cash loan and has gotten his brother ,Chrles to volunteer to cosign the note should the loan be approved. • The bank checks out Mary Earl’s estimate of her monthly take-home pay with Mary’s employer, Brayan Sims Doors and Windows. • 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. • First State Bank of Jackson seeks the opinion of an expert on the outlook for sales growth and production in Mexico before granting a loan to a Mexican manufacturer of auto pars. • The history of Members 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.

31. Please identify which of the six basic C’s of lending –Character, capacity, cash, collateral, conditions, and control- applies to each of the loan factors listed here: • Projected cash flow • Experience of other lenders • Social Security Card • Price-Earnings ratio • Industry outlook • Future financingg needs • Asset liquidation • Inflation outlook • Adequate documentation • Changes in accounting standards • Written loan policy • Coverage ratios • Purpose of Loan • Banking laws and regulations • Changes in technology • Obsolescence • Liens • Management Quality • Leverage • History of firm • Customer identity • Payment record • Partnership agreement • Accounts receivable Turnover • Account Payable Turnover • Wages in the labor market • Insurance coverage • Competitive climate for customers product • Credit rating • Corporate resolution • Liquid reserves • Asset Specialization • Driver’s license • Expected market share • Economist’s forecasts • Business Cycle • Performance of comparable firms • Guarantees/ Warranties • Expense controls • Inventory Turnover