Solution manual bank management and financial services 9th edition by rose, peter chap016

Key Topics in This Chapter  Types of Loans Banks and Competing Lenders Make  Factors Affecting the Mix of Loans Made  Regulation of Lending  Creating a Written Loan Policy  Steps in

CHAPTER 16 LENDING POLICIES AND PROCEDURES: MANAGING CREDIT RISK

Goal of This Chapter: The purpose of this chapter is to learn the steps in a lending process, regulations in the industry, and the importance of lending policies for banks and other lending institutions

Key Topics in This Chapter

 Types of Loans Banks and Competing Lenders Make

 Factors Affecting the Mix of Loans Made

 Regulation of Lending

 Creating a Written Loan Policy

 Steps in the Lending Process

 Loan Review and Loan Workouts

Chapter Outline

I Introduction

II Types of Loans

A Types of Loans:

1 Real Estate Loans

2 Financial Institution Loans

3 Agricultural Loans

4 Commercial and Industrial Loans

5 Loans to Individuals

6 Miscellaneous Loans

7 Lease Financing Receivables

B Factors Determining the Growth and Mix of Loans

III Regulation of Lending

A Relevant Regulations:

B Establishing A Good Written Loan Policy

IV Steps in the Lending Process

1 Finding Prospective Loan Customers

2 Evaluating a Prospective Customer’s Character and Sincerity of Purpose

3 Making Site Visits and Evaluating a Prospective Customer’s Credit Record

4 Evaluating a Prospective Customer’s Financial Condition

5 Assessing Possible Loan Collateral and Signing the Loan Agreement

6 Monitoring Compliance with the Loan Agreement and Other Customer Service Needs

V Credit Analysis: What Makes a Good Loan?

A Is the Borrower Creditworthy? The Cs of Credit

1 Character

2 Capacity

3 Cash

4 Collateral

5 Conditions

6 Control

B Can the Loan Agreement Be Properly Structured and Documented?

C Can the Lender Perfect Its Claim Against the Borrower's Earnings and Any Assets That May Be Pledged as Collateral?

1 Reasons for Taking Collateral

2 Common Types of Loan Collateral

a Accounts Receivable

b Factoring

c Inventory

d Real Property

e Personal Property

f Personal Guarantees

3 Other Safety Devices to Protect a Loan

VI Sources of Information About Loan Customers

VII Parts of A Typical Loan Agreement

A The Promissory Note

B Loan Commitment Agreement

C Collateral

D Covenants (Affirmative and Negative)

E Borrower Guaranties or Warranties

F Events of Default

VIII Loan Review

IX Loan Workouts

X Summary of the Chapter

Concept Checks 16-1 In what ways does the lending function affect the economy of its community or region?

Bank credit is one of the most important sources of capital that fuels local economic growth and development When banks make loans to support the development of new businesses and to aid the growth of existing businesses, new jobs are created and there is a greater flow of income and spending throughout the local economy

16-2 What are the principal types of loans made by banks?

Bank loans are usually classified by the purpose of the loans The most common classifications are real estate loans, commercial and industrial loans, loans to financial institutions, credit-card and other loans to individuals, lease financing, and agricultural loans Bank loans may also be classified by maturity—short term, medium-term, and long-term loans

16-3 What factors appear to influence the growth and mix of loans held by a lending

institution?

The particular mix of any lending institution's loan portfolio is shaped by the characteristics of its market area, the expected yield and cost associated with each type of loan, loan participations, size of the lending institution, experience and expertise of the management, the institution’s written loan policy, expected yields, and regulations

16-4 A lender's cost accounting system reveals that its losses on real estate loans average 0.45 percent of loan volume and its operating expenses from making these loans average 1.85 percent

of loan volume If the gross yield on real estate loans is currently 8.80 percent, what is this lender's net yield on these loans?

The bank's net yield on real estate loans is gross yield as reduced by costs associated with the loans:

Therefore, net yield on real estate loans will be: 8 - 0.45 + 1.85 = 6.45% 

16-5 Why is lending so closely regulated by state and federal authorities?

Access to credit for individuals and businesses is quintessential for any economy However, irrational lending can sometimes result in huge bad loans for the lending institutions If a lender

is under capitalized, it may even lead to bankruptcy during stressed economic conditions

Empirical evidences suggest that liquidity in banking sector is severely affected due to cascading effects and it takes a long time before free-flow of credit returns in the industry This has direct fallout on the health of the economy Regulation also protects consumers against discrimination Therefore, it is essential that the lending institutions be closely regulated

16-6 What is the CAMELS rating and how is it used?

CAMELS is a rating system used by federal bank examiners to evaluate the overall health of a bank It is an abbreviation for each of the six factors used to assess the bank The letters in the word are derived from—Capital adequacy, Asset quality, Management quality, Earnings record, Liquidity position, and Sensitivity to market risk

16-7 What should a good written loan policy contain?

A good written bank loan policy should contain the characteristics and goals of the loan

portfolio, the authorities and responsibilities of loaning officers, and clearly laid down operating procedures for loaning funds It should provide details of the required documentation and

collateral It should define an institution’s principal trade area, maximum lending with respect to the institution’s capital, minimum acceptable credit ratings, and the process of determination of interest rates chargeable Methods of dealing with non-performing assets should also be included

in the policy

16-8 What are the typical steps followed in receiving a loan request from a customer?

A loan officer usually takes or receives such a request initially and passes it along to the credit analysis division for technical review Usually the recommendations of both the credit analyst and the loan officer are directed to a loan supervisor or loan committee for approval The loan committee assesses the possible loan collaterals offered and decides on whether to approve the customer’s request Once approved, the loan committee must monitor to ensure that the terms of the loan are being followed and to address any other service needs that the customer may have

16-9 What three major questions or issues must a lender consider in evaluating nearly all loan requests?

The key issues that a lender must consider while evaluating any loan request are:

1 Is the borrower creditworthy?

2 Can the loan agreement be properly structured and documented?

3 Can the lender perfect its claim against the borrower's earnings and any assets that may

be pledged as collateral?

16-10 Explain the following terms: character, capacity, cash, collateral, conditions, and control

a Character – Character assessment involves finding out the purpose of credit request by a customer and the intention of the borrower to repay the funds

b Capacity – Capacity is a customer’s authority to request a loan and the legal standing to sign a binding loan agreement

c Cash – Cash is the ability of a customer to generate sufficient cash flows to service the

principal and interest amount on the loan as and when they become due

d Collateral – Collateral refers to an asset pledged by a borrower as a security with the lending institution against loaned funds

e Conditions – Conditions refer to the current economic situations in the borrower’s line of work This is important because the ability of the borrower to generate cash flows may be

affected by change in conditions

f Control – The control element refers to considerations regarding the impact of changes in law and regulation that can adversely affect the borrower and whether the loan request meets the lender’s and the regulatory authorities’ standards for loan quality

16-11 Suppose a business borrower projects that it will experience net profits of $2.1 million, compared to $2.7 million the previous year, and will record depreciation and other noncash expenses of $0.7 million this year versus $0.6 million last year What is this firm’s projected cash flow for this year? Is the firm’s cash flow rising or falling? What are the implications for a lending institution thinking of loaning money to this firm? Suppose sales revenue rises by $0.5 million, cost of goods sold decreases by $0.3 million, while cash tax payments increase by $0.1

million and noncash expenses decrease by $0.2 million What happens to the firm’s cash flow? What would be the lender’s likely reaction to these events?

(Note: Assume the noncash expense is already included in the cost of goods sold.)

The firm's projected cash flow can be estimated by adding non-cash expenses (depreciation) to its net income

Cash flow of the firm in the previous year: $2.7 + $0.6 = $3.3 million

Expected cash flows in the current year: $2.1 + $0.7 = $2.8 million

Clearly the firm's cash flow is falling The lending institution needs to find out the reasons for this decline before committing any funds

Under the new scenario, the implications for the cash flows would be:

Sales revenue $0.50

Costs of goods sold 0.30

Cash tax payments -0.10

Noncash expenses -0.20

Since the cash flows for the firm have risen by $0.5 million, it should be more comforting for the lender to loan out funds to the borrower

16-12 What sources of information are available today that loan officers and credit analysts can use in evaluating a customer loan application?

Lending institutions, nowadays, have access to multiple sources of information that they can use

to evaluate a loan application from a customer For corporates, financial statements supplied by the borrower, ratings provided by credit rating agencies, and industry-wide performance ratios for comparison purposes supplied by such organizations as Dun and Bradstreet and Risk

Management Associates (RMA) are widely used For individuals, a lender can contact the one of the various credit bureaus to find out a customer’s credit history of a customer The lending institution may also contact other lenders to determine their experience with the borrowing customer

16-13 What are the principal parts of a loan agreement? What is each part designed to do? The most important parts of loan agreements include a promissory note, a loan commitment agreement, collateral, covenants, and a section listing events of default

A promissory note states the principal amount, the interest rate, and the terms of the loan A loan commitment agreement is a document in which the lender promises to make the loan available to the borrower over a designated future period up to a maximum amount in return for a

commitment fee Covenants specify what the borrower must and must not do Collateral refers to the assets pledged by the borrower to protect the lender’s interests A listing of events of default

states the actions that the lender of the loan is legally authorized to take in order to secure the funds in the event of default by the borrower

16-14 What is loan review? How should a loan review be conducted?

Loan review is a process of periodic review of outstanding loans on an institution's books to make sure each loan is paying out as planned, all necessary documentation is present, and the bank's loan officers are following the institution's loan policy It also involves regularly

reviewing a borrower’s financial health which may change as a result of change in economic variables The exercise helps senior management and the bank's board of directors in assessing the overall exposure to risk and its possible need for more capital in the future While lending institutions today use a variety of different loan review procedures, few general procedures that are followed by nearly all lending institutions include:

1 Carrying out reviews of all types of loans on a periodic basis

2 Structuring the loan review process carefully to make sure the most important features

of each loan are checked

3 Reviewing the largest loans most frequently

4 Conducting more frequent reviews of troubled loans

5 Accelerating the loan review schedule if the economy slows down or if industries in which the bank has made a substantial portion of its loans develop significant problems 16-15 What are some warning signs to management that a problem loan may be developing?

Loans characterized by reduced communication between borrower and lender, delays in

receiving financial reports, evidence of revaluations of assets (such as inventory or pension-plan assets), declining stock prices, changes in management, consistently declining profits, change in credit rating, or restructuring of other loans the borrower has taken out are often considered as indications of a developing problem loan

16-16 What steps should a lender go through in trying to resolve a problem loan situation? While workout of each problem loan may depend on the circumstances due to which the loan has turned underperformer, some of the common steps involved include:

1 The goal of all loan workouts should be to maximize the chances of recovery of funds

2 Problems with any loans should be quickly detected and reported

3 Loan workout process should be independent of the lending function to avoid any

conflict of interest

4 Loan workout specialists should conduct a preliminary analysis of the problem and its possible causes and confer with the troubled customer quickly on the possible options, including any financial and operational restructuring

5 A preliminary plan of action should be developed after determining the risk exposure, sufficiency of loan documents, and estimated liquidation values of assets and deposits

6 Loan workout personnel should conduct a tax and litigation search to check for any other unpaid liabilities of the borrower

7 For business borrowers, loan personnel must evaluate the quality, competence, and integrity of current management

8 Loan workout professionals must consider all reasonable alternatives for cleaning up the troubled loan including an option to seek a revised loan agreement

Problems & Projects 16-1 The lending function of depository institutions is highly regulated and this chapter gives some examples of the structure of these regulations for national banks In this problem you are asked to apply those regulations to Red Rose National Bank (RRNB) Red Rose has the

following sources of funds: $300 million in capital and surplus, $325 million in demand deposits,

$680 million in time and savings deposits, and $200 million in subordinated debt

a What is the maximum dollar amount of real estate loans that RRNB can grant?

The total volume of real estate loans granted by a U.S national bank cannot exceed that bank’s capital and surplus or 70 percent of its total time and savings deposits whichever is higher

Capital and surplus: $300 million

70 percent of time and savings deposit: $680 × 70 percent = $476 million

Therefore, maximum amount of real estate loans that RNRB can grant is $476 million

b What is the maximum dollar amount RRNB may lend to a single customer?

A depository institution can provide an unsecured loan of a maximum of 15 percent of its

unimpaired capital to a single customer This can be further extended by another 10 percent if the loan amount exceeding 15 percent is fully secured by marketable securities

Therefore, maximum amount of unsecured that RNRB can provide to a single customer is:

$300 × 15% = $45 million

A further amount of $300 × 10% = $30million can be loaned against fully secured marketable securities

16-2 Motivation Corporation, seeking renewal of its $12 million credit line, reports the data in the following table (in millions of dollars) to Hot Springs National Bank’s loan department Please calculate the firm’s cash flow as defined earlier in this chapter What trends do you observe, and what are their implications for the decision to renew or not renew the firm’s line of credit?

20X1 20X2 20X3 20X4

Projections for Next Year

Costs of Goods Sold $5.1 $5.5 $5.7 $5.8 $6.0

Selling and Admin Exp $8.0 $8.0 $8.0 $8.1 $8.2

Depreciation and other noncash expenses $11.2 $11.2 $11.1 $11.0 $11.0

Taxes Paid in Cash $4.4 $4.6 $4.9 $4.8 $4.8

(Note: Assume the noncash expense is already included in the cost of goods sold.)

Cash flows for a firm can be calculated as:

Sales Revenues - Cost of Goods Sold - Selling and Admin - Taxes Paid in Cash + Non Cash Expenses Therefore, the cash flows for Motivation Corporation for each year will be:

Projections for Next Year $1.80

Cash flows for the firm have been rising steadily, suggesting that the firm would have less

trouble making required loan payments The lender, though, needs to check if the projections for next year seem reasonable since borrowers are sometimes over optimistic about future

opportunities However, if the projections are reasonable, Hot Springs National Bank may

consider renewing the loan

16-3 Parvis Manufacturing and Service Company holds a sizable inventory of dryers and

washing machines, which it hopes to sell to retail dealers over the next six months These

appliances have a total estimated market value currently of $30 million The firm also reports

accounts receivable currently amounting to $24,650,000 Under the guidelines for taking

collateral discussed in this chapter, what is the minimum size loan or credit line Parvis is likely to receive from its principal lender? What is the maximum size loan or credit line Parvis is likely to receive?

For advances against accounts receivables, a lender takes a security interest in the form of a

stated percentage usually between 40 to 90 percent of the face amount, depending upon the

perceived quality of the receivables while for advances against inventories, a lender will usually advance only 30 to 80 percent of the estimated market value of a borrower's inventory to leave a substantial cushion in case of decline in the inventory's value

Therefore, the minimum size loan or credit line for Parvis will be:

$30 × 0.3 + $24.65 × 0.4 = $18.86 million

And the maximum size loan or credit line for Parvis will be:

$30 × 0.8 + $24.65 × 0.9 = $46.185 million

16-4 Under which of the six Cs of credit discussed in this chapter does each of the following pieces of information belong?

The particular C of credit represented by each piece of information presented in this problem was

as follows:

a First National Bank discovers there is already a lien against the fixed assets of one of its

customers asking for a loan

b Xron Corporation has asked for a type of loan its lender normally refuses to make

Control

c John Selman has an excellent credit rating

Character

d Smithe Manufacturing Company has achieved higher earnings each year for the past six years Cash

e Consumers Savings Association’s auto loan officer asks a prospective customer, Harold Ikels, for his driver’s license

Capacity

f Merchants Center National Bank is concerned about extending a loan for another year to Corrin Motors because a recession is predicted in the economy

Conditions

g Wes Velman needs an immediate cash loan and has gotten his brother, Charles, to volunteer to cosign the note should the loan be approved

Character

h ABC Finance Company checks out Mary Earl’s estimate of her monthly take-home pay with Mary’s employer, Bryan Sims Doors and Windows

Cash

i 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

Conditions

j First State Bank of Jackson seeks the opinion of an expert on the economic outlook in Mexico before granting a loan to a Mexican manufacturer of auto parts

Control

k The history of Membres 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

Capacity

l Home and Office Savings Bank has decided to review the insurance coverages maintained by its borrowing customer, Plainsman Wholesale Distributors

Collateral

16-5 Butell Manufacturing has an outstanding $11 million loan with Citicenter Bank for the current year As required in the loan agreement, Butell reports selected data items to the bank

each month Based on the following information, is there any indication of a developing problem loan? About what dimensions of the firm’s performance should Citicenter Bank be concerned?

Cash account (millions of dollars) $33 $57 $51 $44 $43 Projected sales (millions of dollars) $298 $295 $294 $291 $288 Stock price per share

(monthly average) $6.60 $6.50 $6.40 $6.25 $6.50 Capital structure (equity/debt ratio

Liquidity ratio (current assets/

current liabilities) 1.10x 1.23x 1.35x 1.39x 1.25x Earnings before interest and taxes

(EBIT; in millions of dollars) $15 $14 $13 $11 $13 Return on assets (ROA; percent) 3.32% 3.25% 2.98% 3.13% 3.11% Sales revenue (millions of dollars) $290 $289 $290 $289 $287

Butell has announced within the past 30 days that it is switching to new methods for calculating depreciation of its fixed assets and for valuing inventories The firm’s board of directors is

planning to discuss at its next meeting a proposal to reduce stock dividends in the coming year Selected items reported to the bank by the company do indicate the possible development of a problem loan situation For one thing, Butell's cash account has fallen sharply in the latest month after several months of a substantial uptrend and the firm's liquidity ratio of current assets to current liabilities has declined significantly in the last 3 months Decreases in the firm's liquidity position may be signaling difficulty in maintaining enough cash to meet near-term liabilities Another possible cause for concern centers around Butell's capital structure as its ratio of equity capital relative to debt financing is falling, indicating that creditors (including Citicenter Bank) are providing a larger share of the firm's capitalization Raising fixed cost capital amidst falling liquidity implies rising risk for the creditors However, these changes in liquidity and capital structure may only reflect normal seasonal pressures and may not be real problems for the bank, especially because other fundamental aspects of Butell's recent performance—its stock price, earnings before interest and taxes, and ROA seem to be improving

Perhaps of greater moment is the decline of sales revenue below Butell's projections As of the latest month sales revenue reached $290 million versus a projection of $298 million Citicenter Bank must determine the causes of this sales shortfall to see if the firm is encountering

increasing resistance to sales for any of its product lines However, even this trend may not be a cause for alarm because sales may well be highly volatile in the industry in which Butell