Bank lending

B- Bank lending

Banks are experts at analyzing financial condition of potential borrowers. Depth of analysis depends on size of the loan, type of loan (revolving line of credit, seasonal loan backed by inventory or receivables, or term loan with lien on some asset), and whether or not the applicant is known to the bank. Naturally, the type of loans a bank is willing to offer is at the heart of its strategy, and that determines the parameters for pricing different loans, which was outlined in Chapter 3 Section C. There are four phases of a bank's financial analysis: at the initial application, upon approval by the credit committee, by the credit review department, and during the monitoring of the loan. For a complete discussion, one should consult a manual on commercial lending. The following is an outline of essential aspects of how analysis of short term loans is organized in a typical American bank.

1) - Initial bank loan application, interview and negotiation with loan officer

A local branch loan officer who receives an initial inquiry from a potential borrower, must conduct a complete analysis of the client. The first step is to determine whether the type of loan the client wants is available from the bank (i.e. if it is part of bank's strategy). The loan officer will reject a request if i) the information provided is insufficient, ii) the bank does not offer the type of financing requested, or iii) there is doubt as to the ability of the borrower to repay the loan. If the request is not rejected, the loan officer is then responsible for gathering of all the information essential to conduct a complete investigation of the applicant.

The information requested is usually a business plan with financial statements for the past three years, cash flow statements, tax returns, pro forma (or projected) statements and budgets, such as, especially, a cash budget (described in Chapter 8 Section J-5). A cash budget is essential for a revolving line of credit and a season loan because it must show the pattern of loan repayment down to zero. Since a cash budget covers only 12 months, it is not as crucial for term loans with installments extending over several years, but it still illustrates a company's handling of its obligations.

Other information that may be needed deals with the nature of the activity or asset being financed, documents related to the collateral or personal financial statements of business owners, especially if the firm is a closely held corporation, a partnership or sole proprietorship. The bank officer must also supplement all the documents received with personal observations about the applicant. It is during a crucial initial interview that judgmental observations about the applicant are recorded by the loan officer while checking the completeness of the loan application with its supporting documents.

Later, a visit to client's premises is common. Bank and trade references are virtually always required. The investigation involves the use of credit reporting agencies, inquiries to other banks of the client, checking public records for liens or judgments against applicant, as well as assembling all relevant information about the nature of the industry and the history of the company.

The basis of the evaluation of a client rests on the well known 5 C's of banking:
- character or determination of the borrower to meet its future obligation,
- capacity or ability to generate the cash flows to repay the loan from normal operations,
- capital which the owner must have put in the business for the business to run,
- conditions of the economy and the industry that will not threaten the business,
- collateral which is pledged by the borrower as a secondary - but in no case, as primary - source of loan repayment.

A financial analysis helps confirm with precise statistics, that there isn't an excessive risk in the client's ability to meet its obligations from a study of its
- working capital (see Chapter 8 Section C)
- current and quick ratio position (see Chapter 8 Section D)
- ability to cover its expenses (see Chapter 11 Section C-4)
- structure of its debt (see Chapter 11 Section D-3)

All this is studied in a comparative manner relative to prior years and to other companies in the industry. To obtain all the financial information in a standardized format, the financial data is entered into a spreadsheet and the ratios are derived automatically by computer: this is called spreading. Banks in the United States use comparative ratios compiled for approximately 800 industries by Robert Morris Associates in the annually published manual called "Annual Statements Studies" (already mentioned in Chapter 1 Section D-2, and which contents are further discussed on several occations).

Number crunching is only part of analytical work, the loan officer must gain confidence that the numbers match reality. Naturally, the auditor's opinion which accompanies the financial statements must be a clean one, with no reference to limitation of scope of work or contingencies. More importantly, a visual inspection of client's operations must take place during a visit. The visit should reveal qualitative aspects of company premises, its staff and its products. When a collateral is pledged, the analytical process must include a physical inspection of the assets and a reading of the title to the property. If the assets pledged as collateral remain in a field warehouse, or are left in the hands of the borrower, the legal department of the bank must also review the loan documents and file a lien on the assets with the proper authorities (usually the county clerk of the county where the company is located). A bank's legal department may not need to be involved if the assets are placed in a public warehouse, but procedures for control over the movement of assets must be spelled out in the loan agreement.

Above all, the loan officer must become confident that the people who run the company have the drive and skills to fulfill the goals set out in the business plan. How these managers relate to their customers, to one another and to their staff, is an essential part good management. There isn't just only one organizational structure or one management style that will assure success and ability to pay back loans. Centralized or decentralized, authoritarian or based on delegation of responsibility, structured by functions or products, any of these can be effective. The loan officer must verify that the way workers relate within the organization is not stifling, and likely to bring about problems in the future.

The greater the amount borrowed, the more extensive is the analysis, and the higher is the approval in bank hierarchy. A local branch loan officer can approve small or moderate size loans. While the exact dollar limits vary considerably from bank to bank, and depends significantly on the work experience of each individual loan officer, there is usually a limit for each loan a lending officer can approve (for instance, $100,000), and there is an overall limit for the total of all loans approved by a given lending officer (for instance, $1,000,000). If one of these limits is exceeded, a loan application has to be taken to the branch manager who has higher limits. Even larger loans go to a credit committee. A loan that represents a major risk (as well as profit opportunity) for the entire bank would have to receive the approval of bank's president.

The loan officer negotiates with applicant the terms that are most appropriate for the company, and that generate adequate bank interest income for a tolerable risk. As outlined in the previous chapter, the interest rate decided upon gives recognition to the cost of obtaining funds, the risk present in the loan, the administrative and servicing costs, as well as the bank's income targets and other revenue opportunities (such as that from fees and services). In determining the risk level of the loan, a rating system is often used where, essentially, the various aspects of the 5 C's are given different weights in arriving at the creditworthiness of the client. The rating of the loan and the assigning of the interest to charge, are essentially the process of pricing (or valuation) of the loan already discussed in the Chapter 3 Section 3C-1.

The matrix that sets the additional points for each type of loan risk grades, is a reflection of the bank's strategy to attract or discourage certain types of loans. Interest rate risk increases with the length of loan maturity, anticipated changes in the economy and the exposure of the bank stemming from its sources of funds. A bank formulates its assets-liability strategy so as to minimize exposure while seeking the desired level of high revenue generating loans. Naturally, profitable loans are those that have longer maturity, and bear higher company risk. Long term loans are also the source of interest rate risk for those banks that must obtain their funds from short term depositors.

To deal with interest rate risk, there are hedging techniques, such as entering into interest rate swaps, maturity swaps and other future contracts (which are beyond the scope of this text, but briefly described for non-financial firms in Chapter 12 Section G). But, there is cost in hedging risk. Banks continuously reassess their interest rate sensitivity and adjust their hedging strategy. Interest rate sensitivity and the size of the exposure depend a great deal on what will happen to interest rates and the economy in the future. Thus, the importance of interest rate and economic forecasting (on which interest rate forecasting is predicated), becomes apparent. The factors affecting interest rates are listed in Chapter 2 Section D, and analytical techniques used in interest rate forecasting are illustrated in Chapter 15 Section C.

The most flagrant example of a failure to deal adequately with interest rate risk is that of American Savings and Loans Associations (S&L's) in late 1980's and early 1990's. Traditionally, these banks made private home mortgage loans locally using savings deposits that were quite stable because of fixed interest rates earned on these accounts by mostly local small depositors. In the early 1980's deregulation in the banking industry caused other banks to compete away a portion of S&L's savings deposits, and opened the door for S&L's ability to make other loans and to own certain securities and real estate properties. S&L's were forced to fight back for their source of funds by offering NOW and money market accounts. The latter are short term and far more unstable and costly sources of funds than fixed rate savings accounts. S&L's attempted to regain some of their lost profitability by making commercial loans and buying into real estate developments. As these investments turn out to more risky than expected and interest rates on money market accounts rose slightly, the situation became desperate: they held long term assets that did not generate the expected revenue, while having to pay increasingly more to retain their depositors. Within a decade, two thirds of S&L's had closed down or were absorbed by other banks.

See review questions Q-4B1.1 through Q-4B1.13.

2)- Credit committee:

A credit committee is comprised of members of credit, treasurer and controller departments. A loan officer must convince the credit committee that the loan he wishes to approve will be profitable for the bank taking into consideration bank's strategy, borrower's risk and opportunities for future business with borrower. The terms of the loan must already have been worked out with the prospective borrower. The presence of the treasurer in the committee ensures that a proper consideration is given to sourcing of the funds necessary for the loan. The controller verifies that proper procedures have been followed in processing the loan application, investigation and financial analysis. The treasurer and controller may also look at the timing of the exposure resulting from the loan. The credit department members review the loan and verify that the loan is compatible with the overall lending strategy of the bank.

See review questions Q-4B2.1 and Q-4B2.2.

-- Example of loan approval --

3)- Credit review department:

Each loan is analyzed by the credit review department to determine the characteristics of bank's loan portfolio and to assist the credit committee in lending decisions. A credit review may involve as much investigation as the initial one by the loan officer, with the exception of interviews with or visits to clients. Financial analysis is performed in a uniform pattern on all loans so that characteristics of each loan are consistent with bank's overall loan portfolio. Furthermore, review takes place periodically to monitor loan performance for each loan officer and each branch so that deviations can be brought to the attention of parties involved. This is the only systematic way of discovering departure from bank's planned strategy, and specifying corrective measures. Finally, credit review is necessary for the control function.

Recapitulating, the periodic review of the entire loan portfolio of the bank helps to formulate bank's loan strategy, to assess bank's exposure, to set asset-liability management goals, to prevent fraud and to notify loan officers whose loans are out of line with bank strategy. There are three dimensions to a bank's loan strategy. First the strategy seeks to determine the income level of bank's loan portfolio, and to compare that return to the cost of obtaining funds. Second, the timing of bank's collections and bank's obligations reveals the exposure of the bank over time: this tells what changes are necessary in obtaining new funds or in scheduling new loan repayments. The exposure also depends on the previously mentioned interest rate sensitivity of assets and liabilities. Third, an exposure measured by industry or region shows if a change is necessary in marketing approach to potential clients. In addition, the credit review provides data on problem loans which can be instrumental in avoiding them in the future.

Problem loans are notoriously difficult to deal with. Many end up being written off as total loss without any chance of recovery. In light of net returns on assets of banks being on average less than one percent, and in some years, less than half of one percent, it is clear that even a 2 or 3% of loan loss is very penalizing. This points to the high cost of poor quality financial analysis. Indeed, in articles and books on the debacle of S&L's discussed in the previous example, many writers reported as one of the major contributing factor in S&L's demise, was that the S&L's were not used to conduct analysis on commercial loans.

-- Example of bank strategy of asset/liability management affected by loan reviews: for instance, a case illustrating timing exposure --

See review questions .

4)- Monitoring of loans:

All new information pertaining to each borrower a loan officer has, must be received regularly by that loan officer. In particular, any delay in prompt payment of loan obligations must come to his/her attention immediately. With updated financial information (e.g. quarterly reports), a new financial analysis is conducted by the loan officer (as well as the credit review department during its periodic reading of files) to make sure that the plans the borrower presented with the application are not falling apart. If something is taking place that is undesirable, actions must be initiated. Actions are at least of three kind. First, the loan officer should visit or talk with the borrower to determined the extent of the problem. Second, the loan may need to be reclassified in one of the lower classifications reflecting the decrease in value the loan represents to the bank. At the same time as the reclassification a reserve may need to be set up for the potential loss that the downgrading represents, as it was outlined in Chapter 3 Section 3C-2. Finally, the loan officer may seek the assistance of the legal department to protect the interests of the bank.

-- Example of bank credit analysis failure and problem loan showing causes of problem loans as being either due to errors made by the loan officer or due to the borrower --

In 1995. Russian bank lending is characterized by the following:
- loans are almost entirely short term, averaging less than 6 months;
- collateral is required;
- use of real estate mortgage is plagued by unclear statutes on property ownership; usually the pledge is carried out in the form of a conditional transfer of title to the bank, which is exercised if the borrower fails to meet his/her obligations;
- extremely few loans are available for small businesses because of their shaky future, although a small pool of government (as well as foreign development agencies) funds are channeled to them through designated banks;
- financial data of companies is available quarterly, but is known to be blatantly distorted and loan officers use financial analysis with skepticism;
- over one quarter of all loans are "prolongated", that is, loans that are non-performing or loans initially applied for as short term but used for long term purposes.

A survey of a small group of banks in late 1994, revealed that
- Russian banks are generally more centralized than foreign banks,
- credit committees have much power and may include top executives of banks,
- loan officers are either former Soviet banking staff with many years of service, or very young new university graduates, but only very few experienced professionals with modern banking experience,
- lending by individual banks is often concentrated in a region, a sector of the economy or a small group of those organizations which funded and created the bank in the first place.

See review questions Q-4B3.1 through Q-4B3.6.

See research assignments R-4.3, R-4.4 and R-4.5.

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Last modified: Jun/01/01 Next: Leasing