The following information may be useful to students of Banking and Financial Markets and Institutions. They are also required to read other Text Books and References.
BANKS`s Loan Policies
Factors that Influence a Bank’s Loan Policies
The restrictions imposed by statutory law and administrative regulations do not provide answer to many questions regarding safe, sound and profitable bank lending, questions regarding the size of the loan portfolio, desirable loan maturities, and the types of loans to be made are unanswered. These questions and many others about lending must be answered by each individual bank. Many banks have developed formal, written lending policies in recent years. Although written lending policies serve a number of purposes, the most important is that they provide guidance for lending officers and thereby establish a greater degree of uniformity in lending practices. Since lending is important both to the bank and to the community it serves, loan policies must be worked out carefully after considering many factors. For the most part, these same factors determine the size and composition of the secondary reserve and the investment account of a bank. Some of the very important factors are mentioned here and discussed only briefly:
1. Capital position
2. Risk and profitability of various types of loans
3. Stability of deposits
4. Economic Conditions
5. Influence of monetary and fiscal policy
6. Ability and experience of bank personnel
7. Credit needs of the area served
The Capital of a bank serves as a cushion for the protection of the depositor`s funds. The size of the capital in relation to deposits influences the amount of risk that a bank can afford to take. Banks with a relatively large capital structure can make loans of longer maturities and greater credit risk.
Risks and Profitability of Different Types of Loan
Since earnings are necessary for the successful operation of a bank, all banks consider this important factor in formulating loan policy. Some banks may emphasize earnings more than others. Banks with greater need for earnings might adopt more aggressive lending policies than those that do not consider earnings to be paramount. An aggressive policy might call for making a relatively large amount of term or consumer loans, which normally are made at higher rates of interest than short-term business loans.
The Stability of Deposits
The fluctuation and types of deposits must be considered by a bank in formulating its loan policy. After adequate provisions have been made for the primary and secondary reserves, banks can then engage in lending. Even though these two reserves are designed to take care of predictable deposit fluctuations and loan demands, unpredictable demands force banks to give consideration to the stability of deposits in formulating loan policy.
The economic conditions of the area served by a bank are important in demining its loan policy. A stable economy is more conducive to a liberal loan policy than is one that is subject to seasonal and cyclical movements. Deposits of feast or famine economies (weak economies) fluctuate more violently than do deposits in an economy noted for its stability. Consideration must also be given to the national economy. Factors that adversely affect the nation as a whole, if they are of serious magnitude, eventually affect local conditions.
Monetary and Fiscal Policies
The lending ability of banks is also influenced by monetary and fiscal policies. If monetary and fiscal policies are expansionary and additional reserves are made available to the commercial banking system, the lending ability of banks is increased. Under these conditions banks can have more liberal loan policy than if the opposite situation exists.
The Expertise of Banks Personnel
The expertise of lending personnel is not insignificant in the establishment of bank loan policy. For example, officers may have considerable ability and experience in business lending but practically none in making real estate loans, while in other banks their specialty may be consumer lending. One of the probable reasons that banks ere slow in entering consumer lending field is the lack of skilled personnel. Some banks may be so specialized in certain fields of lending that their presence may influence the loan policy of other banks.
The Area Served by Banks
An obvious factor influencing a commercial bank`s loan policy is the area it serves. The major reason banks are chartered is to serve the credit needs of their communities. If this cannot be done, there is little justification for their existence. Banks are morally bound to extend credit to borrowers who present logical and economically sound loan requests. Banks in areas where the economy is predominantly one of cattle raising, for example, cannot turn their back on this type of lending , but should tailor policy to fit the needs of this economic activity.
The Tools Commercial Lenders Need and Use
A good exercise to demonstrate one of the most important tasks that commercial lenders have to do and one that pulls together the various tools they need is to practice writing a credit memo. Seven keys in preparing such memoranda are:
1. Be brief
2. Interpret the information
3. Concentrate on facts
4. Put yourself in the role of the user
5. Maintain a “big picture” perspective
6. Understand the risk (of Business and Banking)
7. Focus on understanding how the business functions
Given these points, credit memos need to address four key areas:
Management: (who are you lending to) important areas to analyse here include stability, past performance, depth, reputation, planning (e.g. projected performance of the company), and strengths and weakness.
Company Operations: ( what do they do and how do they do it?) important areas to analyse here include definition of market ( product and geographic) , structure of the industry, the four Ps of marketing( product, price, promotion and place) and how they relate to the market and industry , degree of competition and substitutes and basic operations of the business.
Industry: (what does the company face?) important areas to analyse here include structure (e.g. cyclical, seasonal, ease of entry /exit, regulated, unionized, etc), description of the industry, company`s position within the industry, position on the product life cycle, industry trends, future concerns and external concerns.
Financial performance: (Quantitative ability to repay?) important areas to analyse here include interpretation of the numbers, analysis and reflections of financial statements ( balance sheet, income-expense, cash flow), understanding trends and changes and how change in financial performance affects business risk. Successful commercial lenders need good communication skills (verbal and written) and, as evidenced by the preceding list, knowledge of finance, accounting, economics, management, marketing and some computer skills.
The Formal Credit Analysis Procedure
The formal credit analysis procedure includes a subjective evalution of the borrower`s request and a detailed review of all financial statements. The loan officer may perform the initial quantitative analysis for the bank manger. The process consists of:
1. Collecting information for the credit file; such as credit history and performance
2. Evaluation management, the company and the industry in which it operates, i.e., evaluation of internal and external factors
3. Spreading financial statements i.e. financial statement analysis
4. Projecting the borrower`s cash flow and thus its ability to service the debt
5. Evaluating collateral or the secondary source of repayment
6. Writing a summary analysis and making a recommendation
The credit file contains background information on the borrower, past and present financial statements, pertinent credit reports, and supporting schedules such as an ageing receivables, a breakdown of current inventory and equipment, and a summary of insurance coverage. If the customer is a previous borrower, the file should also contain copies of the past loan agreement , cash flow projections, collateral agreements and security documents, and narrative comments provided by previous loan officers, and lending is determining the customer`s and copies of all correspondence with the customer. One of the most important aspects of lending is determining the customer`s desire to repay the loan. Although this is critically important it is difficult to measure. Information in the credit file will give the credit officer information on the customer`s repayment history.
The credit analyst also uses the credit file data to spread the financial statements , project cash flow and evaluate collateral. An evaluation of management, the company, and industry is also needed to ensure safety and soundness of the loan. The last step is to submit a written report summarizing the loan request, loan purpose, and the borrower’s comparative financial performance with industry standards, and to make a recommendation. The loan officer evaluates the report and discusses and errors omissions, and extensions with the analyst.
Structuring A Credit Proposal
The following are the key issues to be subject matter of discussion in a credit proposal:
1. Purpose: The purpose of financing sets the main parameters for designing the credit structure, because it affects the safety of repayment and earrings from the business. The proposal should be bankable. The following proposals are relevant for the purpose: [The Indian Institute of Bankers, 2003].
*Compliance of bank`s internal policy (for example financing for preferred sector and sun rise industries).
• The commercial and economic logic of the purpose to be financed.
• The ability and experience of management to handle the proposed venture.
• Compliance with bank`s legal requirements.
• Legal complications arising from the purpose of the financing which may impair the creditworthiness of the advance.
2. Amount: Is it adequate for the purpose? The loan should be need-based, not more and not less. A bank which lends inadequately not caring how the balance requirement will be funded may create problem for itself as well as for the customer.
3. Margin contribution: This is the stake of the proponent in the project. In project lending secured by fixed assets, a cash contribution from the company itself acts as evidence of commitment and cushion to the lenders against failure of the secured assets to generate repayment. In unsecured transactions the focus shifts to the financial mix of debt and equity.
4. Portfolio consideration: Bank`s proposed exposure to the relevant corporate group/industry should be considered. It is not advisable to put all eggs in one basket.
5. Credit risk and term: Banks will wish to limit their exposure to individual high risk and long term advances more tightly than to lower risk and short term advances.
6. Yield: Increasingly banks are concerned with maximizing their yield from the use of their balance sheet and the amount lent can be a significant determinant of the overall return forms the deal. The more the spread, the better for the bank.
7. Legal consideration: Whether the company has borrowing power to borrow the amount and the bank to lend it.
8. Repayment: The key issue is how the bank is to be repaid and what is the margin of error if operations deteriorate. The following factors will be looked into in this regard.
• The type of repayment source
• The quality of repayment source
• The currency of income from the repayment source
• Cash flow protection (i.e. the margin of error)
• Financial flexibility ( i.e. the alternative sources of fund to cover shortages)
• Asset protection to cover the bank if cash flow is inadequate
• The need for good documentation
9. Security and quasi-security: Security whether main or collateral is the banker`s protection against non-payment from the primary repayment source. It is the insurance against failure and takes the form of a legally enforceable claim on tangible assets or a third party guarantee. However, unsecured transactions may be acceptable where cash flow protection is generous and reliable and adequate asset cover is available through the recourse available for genera creditors of the company.
10. Control and Monitoring: The ability to take control of lending situation, before deterioration in borrower`s condition becomes terminal, is crucial. It is achieved by insertion in the documentation of provisions which if breached, will enable the bank to switch over form term facility to one immediately repayable on demand.
11. Designing Credit Faculties: Designing the details of credit facilities within the broad parameters of benefits to the borrower and protection and remuneration for the bank which broadly involves:
• Fixing up cash credit and working capital demand loan limits
• Bills purchase and / or discounting facilities
• Term loan/ deferred payment facilities
• Contingent liabilities limits for LCs and Guarantees
12. Pricing: This is a very important aspect of lending especially in a competitive environment for achieving satisfactory remuneration for the bank. Pricing is based on the directives issued by the central bank from time to time and the market rates. It will consider:
• The risk-reward ratio
• The cost of administration and overheads
• Capital adequacy cost and cost of statutory reserves
• The need to optimize yields on investments