Chapter Sixteen Lending Policies and Procedures Managing Credit

Chapter Sixteen Lending Policies and Procedures: Managing Credit Risk Mc. Graw-Hill/Irwin Copyright © 2013 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Key Topics • 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 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 16 -2

Introduction • However, risky or not, the principal reason many financial firms are issued charters of incorporation by state and national governments is to make loans • Lenders are expected to supply credit for all legitimate business and consumer financial needs and to price that credit reasonably • Loans support the growth of new businesses and jobs within the lender’s market area • Loans frequently convey information to the marketplace about a borrower’s credit quality • The lending process bears careful monitoring at all times Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 16 -3

Types of Loans • • Real Estate Loans Financial Institution Loans Agriculture Loans Commercial and Industrial Loans to Individuals Miscellaneous Loans Lease Financing Receivables • The largest category in dollar volume is real estate loans, followed by loans to individuals, and commercial and industrial (C&I) loans Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 16 -4

TABLE 16– 1 Loans Outstanding for All FDIC-Insured Banks as of December 31, 2010 (consolidated domestic and foreign offices) Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 16 -5

Types of Loans (continued) • Factors Determining the Growth and Mix of Loans ▫ Characteristics of the market area ▫ Lender size ▫ Wholesale lenders vs. retail credit ▫ ▫ Experience and expertise of management Loan policy Expected yield of each type of loan Regulation ▫ General rule: A lending institution should make the types of loans for which it is the most efficient producer Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 16 -6

Regulation of Lending • The mix, quality, and yield of the loan portfolio are heavily influenced by regulation • Examples of lending regulations: ▫ 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 greater ▫ An unsecured loan to a single customer normally cannot exceed 15 percent of a single national bank’s unimpaired capital and surplus account (legal lending limit) • Any loans made are subject to examination and review Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 16 -7

Regulation of Lending (continued) • The Community Reinvestment Act of 1977 ▫ Selected lenders to must make “an affirmative effort” to meet the credit needs of individuals and businesses in their trade territories so that no areas of the local community are discriminated against in seeking access to credit • The Equal Credit Opportunity Act of 1974 ▫ No individual can be denied credit because of race, sex, religious affiliation, age, or receipt of public assistance • The International Lending and Supervision Act ▫ Requires U. S. banks to make public any credit exposures to a single country that exceed 15 percent of their primary capital or 0. 75 percent of their total assets, whichever is smaller ▫ This law also imposes restrictions on the fees lenders may charge a troubled international borrower to restructure a loan Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 16 -8

Regulation of Lending (continued) • Uniform Financial Institutions Rating System ▫ Each banking firm is assigned a numerical rating based on the quality of its asset portfolio ▫ The federal examiner may assign one of these ratings: ▫ ▫ ▫ 1 = strong performance 2 = satisfactory performance 3 = fair performance 4 = marginal performance 5 = unsatisfactory performance Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 16 -9

Regulation of Lending (continued) • Asset Quality ▫ Criticized loans ▫ Scheduled loans ▫ Adversely classified loans ▫ Substandard loans ▫ Doubtful loans ▫ Loss loans Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 16 -10

Regulation of Lending (continued) • CAMELS Rating ▫ Capital adequacy ▫ Asset quality ▫ Management quality ▫ Earnings record ▫ Liquidity position ▫ Sensitivity to market risk exposure • All six dimensions of performance are combined into one overall numerical rating, referred to as the CAMELS rating ▫ Depository institutions whose overall rating is low tend to be examined more frequently than the highest-rated institutions Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 16 -11

Regulation of Lending (continued) • Establishing a Good Written Loan Policy ▫ Important in order to meet regulatory standards ▫ What should a written loan policy contain? ▫ A goal statement for the entire loan portfolio ▫ Specification of lending authority of each loan officer and loan committee ▫ Lines of responsibility in making assignments and reporting information ▫ Operating procedures for soliciting, evaluating and making loan decisions ▫ Required documentation for all loans Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 16 -12

Regulation of Lending (continued) • Establishing a Good Written Loan Policy ▫ Lines of authority for maintaining and reviewing credit files ▫ Guidelines for taking, evaluating, and perfecting loan collateral. ▫ Procedures for setting loan rates and fees and the terms for repayment of loans ▫ A statement of quality standards applicable to all loans ▫ A statement of the preferred upper limit for total loans outstanding ▫ A description of the lending institution’s principal trade area ▫ Procedures for detecting and working out problem loan situations. Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 16 -13

Steps in the Lending Process 1. Finding Prospective Loan Customers 2. Evaluating a Customer’s Character and Sincerity of Purpose 3. Making Site Visits and Evaluating a 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 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 16 -14

Credit Analysis: What Makes a Good Loan? 1. Is the Borrower Creditworthy? The Cs of Credit ▫ Character ▫ Specific purpose of loan and serious intent to repay the loan ▫ Capacity ▫ Legal authority to sign binding contract ▫ Cash ▫ Ability to generate enough cash to repay loan ▫ Collateral ▫ Adequate assets to support the loan ▫ Conditions ▫ Economic conditions faced by borrower ▫ Control ▫ Does loan meet written loan policy and how would loan be affected by changing laws and regulations Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 16 -15

Credit Analysis: What Makes a Good Loan? (continued) 2. Can the Loan Agreement Be Properly Structured and Documented? ▫ This requires drafting a loan agreement that meets the borrower’s need for funds with a comfortable repayment schedule ▫ If a major borrower gets into trouble because of an inability to service a loan, the lending institution may find itself in trouble ▫ Proper accommodation of a customer may involve lending more or less money than requested over a longer or shorter period Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 16 -16

Credit Analysis: What Makes a Good Loan? (continued) 3. Can the Lender Perfect Its Claim against the Borrower’s Earnings and Any Assets That May Be Pledged as Collateral? ▫ Reasons for Taking Collateral ▫ If the borrower cannot pay, the pledge of collateral gives the lender the right to seize and sell those assets ▫ It gives the lender a psychological advantage over the borrower ▫ Types of Collateral ▫ ▫ ▫ Accounts Receivables Factoring Inventory Real Property Personal Guarantees Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 16 -17

EXHIBIT 16– 1 Safety Zones Surrounding Funds Loaned in Order to Protect a Lender Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 16 -18

TABLE 16– 4 Sources of Information Frequently Used in Loan Analysis and Evaluation by Lenders and Loan Committees Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 16 -19

Parts of a Typical Loan Agreement • • The Promissory Note Loan Commitment Agreement Collateral Covenants ▫ Affirmative ▫ Negative • Borrower Guaranties or Warranties • Events of Default Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 16 -20

Loan Review 1. Carrying out reviews of all types of loans on a periodic basis 2. Structuring the loan review process ▫ ▫ ▫ Record of borrower payments Quality and condition of collateral Completeness of loan documentation Evaluation of borrower’s financial condition Assessment as to whether the loan fits with the lender’s loan policies 3. Reviewing Largest Loans Most Frequently 4. Conducting More Frequent Reviews of Troubled Loans 5. Accelerating the Loan Review Schedule if Economy or Industry Experiences Problems Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 16 -21

Loan Workouts • Loan workout – the process of recovering funds from a problem loan situation • Warning Signs of Problem Loans 1. 2. 3. 4. 5. 6. 7. 8. Unusual or unexpected delays in receiving financial statements Any sudden changes in accounting methods Restructuring debt or eliminating dividend payments or changes in credit rating Adverse changes in the price of stock Losses in one or more years Adverse changes in capital structure Deviations in actual sales from projections Unexpected or unexplained changes in deposits Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 16 -22

TABLE 16– 5 Warning Signs of Weak Loans and Poor Lending Policies Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 16 -23

Loan Workouts (continued) • What steps should a lender take when a loan is in trouble? 1. 2. 3. 4. 5. 6. 7. 8. Do not forget the goal: Maximize full recovery of funds Rapid detection and reporting of problems is essential Loan workout should be separate from lending function Should consult with customer quickly regarding possible options Estimate resources available to collect on loan Conduct tax and litigation search Evaluate quality and competence of management Consider all reasonable alternatives ▫ Preferred option: Seek a revised loan agreement Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 16 -24

Quick Quiz • Why is lending so closely regulated by state and federal authorities? • What is the CAMELS rating, and how is it used? • What three major questions or issues must a lender consider in evaluating nearly all loan requests? • Explain the following terms: character, capacity, cash, collateral, conditions, and control. • What sources of information are available today that loan officers and credit analysts can use in evaluating a customer loan application? • What is loan review? Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 16 -25