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fin 440x - exam 2 > The five Cs of Credit > Flashcards

The five Cs of Credit Flashcards

1
Q

What role do commercial banks play in the economy?

A

What role do commercial banks play in the economy?
- Commercial banks act as financial intermediaries between lenders (supplier of funds) and the borrowers (demanders of funds)

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2
Q

What are the largest and most profitable assets for most banks?

A

What are the largest and most profitable assets for most banks?

  • The largest and most profitable assets for banks are by far loans that typically make up 50 to 75 percent of total assets for banks
    • Composition varies among banks depending on size, location, trade area, and lending expertise
    • Returns come from loan interest and fee income
    • Higher returns require taking more risk
    • Banks use loans to cross-sell other products and services
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3
Q

What are the keys to a successful bank loan program?

A

What are the keys to a successful bank loan program?

- Success depends on experience with and knowledge of borrowers’ businesses

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4
Q

What are some of the non-bank competitors for loans

A

What are some of the non-bank competitors for loans

  • The Internet: Many banks now accept and process loan applications online
  • Credit card companies, brokerage firms, insurance companies operate banks or offer products like pre-paid cards
  • Car dealers (Tip: Beware of mark-up!)
  • Payday lenders, pawn shops, check cashing services
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5
Q

What are some of the ways banks manage loan risk?

A

What are some of the ways banks manage loan risk?

  • Loan volume and loan quality must be balanced with the bank’s liquidity requirements, capital constraints and rate of return objectives
  • Loan philosophy determines amount of risk and in what form bank is willing to take
  • Loan policy formalizes lending guidelines and identifies preferred loan types and procedures for granting, documenting and reviewing loans
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6
Q

What two sources of risk were highlighted in class?

A

What two sources of risk were highlighted in class?

  • Credit Risk
    • Entire industries can be affected by general economic conditions
    • Firm specific risks can rise from bad management, changing technology, shifts in consumer preferences/tastes
    • Individual borrower’s ability to repay can be affected by the business cycle
    • Highest risk of charge-offs of any bank asset
  • Interest Rate Risk
    • Loan maturities, pricing and form of principal repayment can affect the timing and magnitude of cash inflow
    • Floating rate/variable rate loans can closely follow funding costs
    • Fixed rate/balloon payment loans generate fewer cash inflows
    • Longer term consumer loans need to be funded by stable deposits to reduce risk from rate changes
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7
Q

What are the five Cs of credit?

A

What are the five Cs of credit?
Character: Will you repay the loan?
Capacity: Can you repay the loan?
Capital: What are your assets and net worth
Collateral: What if you don’t/can’t repay the loan?
Conditions: What general economic conditions can affect your loan payment?

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8
Q

What are the 2 basic factors of the credit process?

A

What are the 2 basic factors of the credit process?

  • The borrower’s commitment or desire to pay the loan back
    • Character: Truthful, willing to pay in all circumstances
    • The viability of the loan purpose
    • Borrower’s history of paying prior debts
  • The borrower’s ability to pay
    • Income, total debt, total assets, the value of collateral relative to the risk of what the loan will be used for
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9
Q

What are the three credit process functions?

A
  1. Business Development and Credit Analysis
  2. Underwriting or Credit Execution and Administration
  3. Credit Review
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10
Q

What are the components of each function? (credit process functions)

A

Business Development and Credit Analysis

  • Market research
  • Advertising, public relations
  • Officer call programs
  • Obtain FS, borrowing resolution, credit reports
  • FS and CF analysis
  • Evaluate collateral
  • Line Officer recommendation (accept/reject)

Underwriting or Credit

  • Execution and Administration
  • Loan committee review of loan proposal
  • Accept/reject, terms negotiated
  • Loan agreement and collateral documentation
  • Borrower signs, obtain collateral, loan funded
  • Perfect security interest
  • File materials in credit file
  • Process payments, obtain periodic FS, call on borrower
Credit Review
Review loan documentation
Monitor compliance with loan agreement
Loan covenants
Delinquencies
Discuss delinquencies or  any other problems
Institute corrective action
Modify credit terms
Additional capital, collateral or guarantees
Call loan
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11
Q

What determines what industries a bank should target?

A

What determines what industries a bank should target?

- Management should target specific industries or markets in which lending officers have expertise

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12
Q

What are the common loan types most banks offer and what are the characteristics of each loan type?

A

What are the common loan types most banks offer and what are the characteristics of each loan type?

  • Notes on loans
    • Loan types and amounts follow the business cycle and trends in service area market
    • As one type of loan increases others may decrease in response to the market
    • Risk-return trade-offs
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13
Q

Types and characteristics

Real Estate Loans

A

Real Estate Loans

  • Construction or development
  • Commercial RE
  • Residential (1-4 family)
  • Multiple family residential (Apts./condos)
  • Secondary mortgage market (OTD)
  • Home equity
  • Farmland
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14
Q

Types and characteristics

Commercial Loans

A

Commercial Loans

  • Working capital (cash to cash cycles)
  • Term to match purpose: Short and long term
  • Revolving credit lines
  • Asset-Based: A/R, inventory, leveraged buyouts
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15
Q

Types and characteristics

Agricultural Loans

A

Agricultural Loans

- Seasonal operating or longer term financing for livestock, equipment and land purchases

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16
Q

Types and characteristics

Consumer Loans

A

Consumer Loans

  • Relatively small amounts
  • Usually to finance the purchase of durable goods
  • Repaid in installments and carry fixed interest rates
  • Credit scoring is often used to evaluate loan requests
  • Installment principal payments increase rate sensitivity
17
Q

What are the 2 potential errors a bank can make when evaluating credit requests

A

What are the 2 potential errors a bank can make when evaluating credit requests

  • Extending credit to a customer who defaults
    - Many banks focus on #1, applying rigid credit evaluation and deny applicants that don’t fit the mold of their ideal borrower. (Community Bank Opportunity)
  • Denying credit to a customer who will repay the loan
18
Q

What is the purpose of credit analysis

A

The purpose of credit analysis is to identify the circumstances under which the bank could lose money
- Lenders should also use credit analysis to restructure weak loan apps or weak existing loans into good loans when borrower could be good but doesn’t understand its true borrowing needs

19
Q

what are the five questions credit analysis should answer?

A

Five Qs credit analysis should answer

  1. What is the character of the borrower, the nature of the loan request and the quality of the info provided
  2. What will the loan proceeds be used for?
  3. How much does the customer need to borrow?
  4. What is the primary source of repayment and when will the loan be repaid?
  5. What is the secondary source of repayment?
20
Q

What are the factors/red flags discussed in class used to assess a borrower’s character?

A

What are the factors/red flags discussed in class used to assess a borrower’s character?

  • Prior banking relationships, dealings with suppliers and customers, credit scores
  • Any significant changes in business structure, management or accountant
  • Borrower’s personal habits: Work ethic, alcohol, drugs, gambling, marital problems
  • Borrower being short of cash: Missed/late payments, overdrafts, numerous small loan requests
21
Q

What are the factors used to assess a loan request, the quality of the borrower’s financial data, and the use of the loan proceeds?

A
  • Assessment of loan request
  • Quality of financial data
  • use of the loan proceeds
22
Q

Assessment of loan request

A

Assessment of loan request

  • Legitimate business purposes with a track record?
  • Speculative?
  • LTV ratios for collateral, maturity
  • Unproven technologies?
  • Inadequate capital, illiquid principals
  • Bank expertise and past experience with the industry
23
Q

Quality of financial data

A

Quality of financial data

  • Audited Statements? Reviewed, Compiled?
  • Beware of “Window Dressing”
  • Changes in accounting methods (i.e., inventory)
  • Extraordinary or discretionary non recurring transactions
  • Income and expense recognition that doesn’t closely track cash flow
  • Non-operating gains and losses
24
Q

Use of the loan proceeds

A

Use of the loan proceeds

  • The need and use of loan proceeds should determine loan maturity, the source and timing of repayment and appropriate collateral
  • Working capital loans to bridge the gap between expenditures on materials, inventory, paying employees and the sale of those goods, A/R and collection
  • Term loans for equipment, acquisitions with economic life beyond one year
25
Q

What are the four basis courses of cash flow?

A

What are the four basis courses of cash flow?

  1. Cash flow from operations
  2. Sale of assets
  3. New debt
  4. New equity issue
26
Q

What should be the sources of repayment of short term loans be? Of long term loans?

A

What should be the sources of repayment of short term loans be? Of long term loans?
- Short term
- Repaid from the sale of inventory or collection of A/R
- Long Term
- From cash flow from operations
Secondary source: Collateral (LTV)

27
Q

What are the four steps in evaluating credit requests?

A

What are the four steps in evaluating credit requests?

  1. Overview of management, operations and the firm’s industry
  2. Common size and financial ratios analysis
  3. Analysis of cash flow
  4. Projections and analysis of the borrower’s financial condition
28
Q

Overview of management, operations and the firm’s industry

A

Overview of management, operations and the firm’s industry

  • Management character and quality
  • The nature of the loan request
  • Data quality
  • Historical trends and developments
  • Characteristics of the business and intensity of industry competition
29
Q

Common size and financial ratios analysis

A

Common size and financial ratios analysis
- Common size financial statement displays all items as percentages of a common base figure rather than as absolute numerical figures. This type of financial statement allows for easy analysis between companies or between time periods for the same company.

fin 440x - exam 2 (6 decks)

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