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

Chapter 16 - Lending Policies and Procedures: Managing Credit Risk 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: Real Estate Loans Financial Institution Loans Agricultural Loans Commercial and Industrial Loans Loans to Individuals Miscellaneous Loans 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 Finding Prospective Loan Customers Evaluating a Prospective Customer’s Character and Sincerity of Purpose Making Site Visits and Evaluating a Prospective Customer’s Credit Record Evaluating a Prospective Customer’s Financial Condition Assessing Possible Loan Collateral and Signing the Loan Agreement 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 16-1 Chapter 16 - Lending Policies and Procedures: Managing Credit Risk Character Capacity Cash Collateral Conditions 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? Reasons for Taking Collateral Common Types of Loan Collateral a Accounts Receivable b Factoring c Inventory d Real Property e Personal Property f Personal Guarantees 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 16-2 Chapter 16 - Lending Policies and Procedures: Managing Credit Risk 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? 16-3 Chapter 16 - Lending Policies and Procedures: Managing Credit Risk 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: Is the borrower creditworthy? Can the loan agreement be properly structured and documented? 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 16-4 Chapter 16 - Lending Policies and Procedures: Managing Credit Risk 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 Costs of goods sold Cash tax payments Noncash expenses Total $0.50 0.30 -0.10 -0.20 $0.70 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 Collateral refers to the assets pledged by the borrower to protect the lender’s interests A listing of events of default 16-5 Chapter 16 - Lending Policies and Procedures: Managing Credit Risk 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: Carrying out reviews of all types of loans on a periodic basis Structuring the loan review process carefully to make sure the most important features of each loan are checked Reviewing the largest loans most frequently Conducting more frequent reviews of troubled loans 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: The goal of all loan workouts should be to maximize the chances of recovery of funds Problems with any loans should be quickly detected and reported Loan workout process should be independent of the lending function to avoid any conflict of interest 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 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 Loan workout personnel should conduct a tax and litigation search to check for any other unpaid liabilities of the borrower 16-6 Chapter 16 - Lending Policies and Procedures: Managing Credit Risk For business borrowers, loan personnel must evaluate the quality, competence, and integrity of current management 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% = $30 million 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 you observe, and what are their implications for the decision to renew or not renew the firm’s line of credit? Projections for 20X1 20X2 20X3 20X4 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 Sales Revenue $7.9 $8.5 $9.2 $9.4 $9.8 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 16-7 Chapter 16 - Lending Policies and Procedures: Managing Credit Risk (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: Year 20X1 20X2 20X3 20X4 Projections for Next Year Cash Flow $1.60 $1.60 $1.70 $1.70 $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 16-8 Chapter 16 - Lending Policies and Procedures: Managing Credit Risk Collateral 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 16-9 Chapter 16 - Lending Policies and Procedures: Managing Credit Risk 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) Projected sales (millions of dollars) Stock price per share (monthly average) Capital structure (equity/debt ratio in percent) Liquidity ratio (current assets/ current liabilities) Earnings before interest and taxes (EBIT; in millions of dollars) Return on assets (ROA; percent) Sales revenue (millions of dollars) One Two Current Month Months Month Ago Ago $33 $57 $51 $298 $295 $294 Three Months Ago $44 $291 Four Months Ago $43 $288 $6.60 $6.50 $6.40 $6.25 $6.50 32.8% 33.9% 34.6% 34.9% 35.7% 1.10x 1.23x 1.35x 1.39x 1.25x $15 3.32% $290 $14 3.25% $289 $13 2.98% $290 $11 3.13% $289 $13 3.11% $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 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 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 16-10 Chapter 16 - Lending Policies and Procedures: Managing Credit Risk operates The bank's loan officer needs to review the customer's earlier sales projections and actual sales revenue to determine if there is a real cause for concern Butell has indicated a recent switch in inventory and depreciation accounting methods Citicenter's loan officer would well to inquire into the reasons for these changes because they may reflect an attempt by the firm to offset actual or potential future losses in some aspect of its operations 16-6 Identify which of the following loan covenants are affirmative and which are negative covenants: a Nige Trading Corporation must pay no dividends to its shareholders above $3 per share without express lender approval Restrictions on payment of dividends represent negative loan covenants b HoneySmith Company pledges to fully insure its production line equipment against loss due to fire, theft, or adverse weather A requirement to insure selected assets is an affirmative loan covenant c Soft-Tech Industries cannot take on new debt without notifying its principal lending institution first Restrictions against taking on new debt represent negative loan covenants d PennCost Manufacturing must file comprehensive financial statements each month with its principal bank The requirement of filing periodic financial statements with the bank is an affirmative loan covenant e Dolbe King Company must secure lender approval prior to increasing its stock of fixed assets A requirement of securing bank approval before adding to a borrower's stock of fixed assets is considered a negative loan covenant f Crestwin Service Industries must keep a minimum current (liquidity) ratio of 1.5× under the terms of its loan agreement Requiring a borrowing customer to maintain a current ratio—a liquidity measure—no lower than 5× is an affirmative loan covenant g Dew Dairy Products is considering approaching Selwin Farm Transport Company about a possible merger but must first receive lender approval The stipulation that prior bank approval of a proposed merger must be obtained is a negative loan covenant 16-7 Please identify which of the basic Cs of lending—character, capacity, cash, collateral, conditions, and control—applies to each of the loan factors listed here: 16-11 Chapter 16 - Lending Policies and Procedures: Managing Credit Risk Insurance coverage Competitive climate for customer’s product Credit rating Corporate resolution Liquid reserves Asset specialization Driver’s license Expected market share Economists’ forecasts Business cycle Performance of comparable firms Guarantees/warranties Expense controls Inventory turnover Projected cash flow Experience of other lenders Social Security card Price-earnings ratio Industry outlook Future financing needs Asset liquidation Inflation outlook Adequate documentation Changes in accounting standards Written loan policy Coverage ratios Purpose of loan Laws and regulations that apply to the making of loans Wages in the labor market Changes in technology Obsolescence Liens Management quality Leverage History of firm Customer identity Payment record Partnership agreement Accounts receivable turnover Accounts payable turnover The particular C of lending which applies to each loan factor is listed below: Character Capacity Cash Collateral Conditions Control Credit rating Corporate resolution Liquid reserves Insurance coverage Competitive climate for Adequate customers product documentation Experience of other lenders Driver’s license Expense controls Asset specialization Expected market share Written loan policy Purpose of loan Social security card Inventory turnover Guarantees and warrantees Business cycle Changes in accounting standards 16-12 Chapter 16 - Lending Policies and Procedures: Managing Credit Risk History of Payment record firm Management Customer quality identity Partnership agreement Projected Asset cash flows liquidation Price earnings Changes in ratio technology Coverage ratios Obsolescence Leverage Liens Performance of comparable firms Industry outlook Inflation outlook Wages in the labor market Accounts Receivables Turnover Economists’ Forecasts Accounts Payable Turnover Future financing needs 16-13 Laws and regulations that apply to the making of loans ... 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... 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... 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