Topic 10 - Managing Loans

Question 1

credit philosophy

Answer 1

An ADI must have a clear credit philosophy which incorporates the organisation’s attitude toward risk and determines it’s priorities

Question 2

credit culture

Answer 2

The ADI has a appropriate credit culture if the behaviour of its staff is closely aligned to its philosophy

Question 3

The objective of the credit management is to

Answer 3

is to control –minimise –loan losse

Question 4

ADIs often conduct “autopsies” to determine the reason for a loan loss and prevent a recurrence Common reasons include:

Answer 4

Failure to receive and analyse financial statements 
Failure to correctly value collateral 
Repeatedly renewing or rewriting loans despite financial difficulty 
Inappropriate lending to high-risk borrowers 
Lending decisions made on the basis of personal relationships

Question 5

The main types of collateral are:

Answer 5

Real property
Personal property in the lender’s possession
Personal property in the borrower’s possession

Question 6

Real property

Answer 6

a registered mortgage is taken out over land and buildings

Question 7

Personal property in the lender’s possession

Answer 7

–e.g. shares or cash deposit

Question 8

Personal property in the borrower’s possession

Answer 8

a charge or equitable mortgage is registered

Question 9

loan review function

Answer 9

This involves periodically auditing loans and the financial situation of borrowers in order to detect any deterioration in loan quality

Question 10

Impaired assets are classified as:

Answer 10

Non-accrual loans
Restructured loans
Assets acquired through security enforcement

Question 11

Non-accrual loans

Answer 11

loans where interest is no longer being paid (typically more than 60 days overdue)

Question 12

Restructured loans

Answer 12

loans where the terms have been renegotiated because the financial difficulties

Question 13

Past due loans

Answer 13

where interest payments are overdue –are not technically impaired assets, but are reported due to the risk they represent

Question 14

The main types of lending are:

Answer 14

1. Small business lending
2. Agricultural loans
3. Corporate lending
4. Project financing
5. Syndicated loans

Question 15

The main types of loans are:

Answer 15

1. Overdrafts
2. Commercial bills
3. Term loans
4. Third-party credits
5. Lease financing

Question 16

Overdrafts

Answer 16

a company is permitted to overdraw its current account up to a pre-agreed limit

Question 17

Commercial bills

Answer 17

A bank may be asked to set up an acceptance or endorsement facility, which typically lasts 3 to 5 years, and effectively gives a company access to medium-term funding, albeit subject to review every time an individual bill matures

Question 18

Term loans

Answer 18

This refers to a business loan with a term exceeding one year

Question 19

Third party credits

Answer 19

Some types of business finance involve contracting with third parties: 
Guarantees and letters of credit 
Accounts receivable financing
Factoring
Inventory financing

Question 20

Guarantees and letters of credit

Answer 20

A bank will guarantee the payment of funds to a third party or guarantee performance under a contract

Question 21

Accounts receivable financing

Answer 21

Funds are advanced using accounts receivable as collateral, and the cash flow from the debtorsis used to repay the loan

Question 22

Factoring

Answer 22

This involves the outright purchase of a customer’s accounts receivable, with the ADI becoming responsible for collection

Question 23

Inventory financing

Answer 23

Funds are advanced using inventory as collateral, and the cash flow from the sale of inventory is used to repay the loan

Question 24

Lease financing

Answer 24

A finance lease is an alternative source of funding for capital equipment 

• A finance lease is not cancellable by the lessee, and the term of the lease is for most of the asset’s life 
• Under a finance lease, instead of lending money to buy the asset, the ADI (the lessor) retains ownership of the asset and allows the lessee to use it in return for lease payments 
• The lessee usually has the option to buy the asset at the end of the lease contract

Question 25

Lending decisions are based primarily on

Answer 25

The character and soundness of the borrower 
The purpose of the loan 
The available sources of repayment

Question 26

Debt/Equity ratio

Answer 26

Total Debt/Total Equity

Question 27

Interest Coverage Ration

Answer 27

Profit before tax and Interest / Interest Expenses

Question 28

Average Collectio Period

Answer 28

Accounts Receivable / Sales per day

Question 29

Inventory Turnover Ratio

Answer 29

Average Cost of Goods Sold / Average Inventory

Question 30

Consumer lending

Answer 30

refers to loans to householders –i.e. non-business customers

Question 31

The main types of credit issued to consumers are:

Answer 31

1. Personal loans
2. Credit cards
3. Home loans

Question 32

Personal loans

Answer 32

Personal loans can be made for a variety of purposes (e.g. cars, travel, furniture, debt consolidation) and may or may not be secured
The most common is an instalment loan
A line-of-credit facility is also one

Question 33

instalment loan

Answer 33

which has a fixed term and is repaid with periodic payments of interest and principal

Question 34

ine-of-credit facility

Answer 34

is similar to an overdraft, allowing personal accounts to be overdrawn

Question 35

The financial affairs of a loan applicant need to be carefully analysed in order to assess his or her capacity to repay the loan Two broad methods are used:

Answer 35

The gross income method is based on the adequacy of the surplus of gross income over fixed obligations 

The net income method also considers the average living expenses of the family unit

Question 36

DiscusswhatismeantbyanADI’screditculture.Howcouldthisbeeffectivelyconveyed withinanorganisation?

Answer 36

AnADI’screditculturecapturestheorganisation’sattitudetoriskinlending.Itexiststo ensure that the credit philosophy and loan policy is appropriately supported and communicatedtoallstaff.Onaday‐to‐daybasisthecreditcultureisstrongifeach individual’sdecisionmakingisconsistentwithmanagementpriorities.

Question 37

DescribehowanADI’screditphilosophyisreflectedintheriskandreturnoftheloan portfolio.

Answer 37

Thecreditphilosophyofanorganisationisdependentintheprofitexpectationofthe ownersandshareholders.Acreditphilosophywhichemphasisesstrongloangrowthwill havemoreflexiblecreditstandardsandbemoreacceptingofhigherriskassets.Expected returnswillbehigher,butgiventhehigherriskprofileofassets,revenueswilltendtobe morevolatile.Amoreconservativecreditphilosophy,ontheotherhand,willtendtohave higher credit standards, slower growth and a lower risk asset portfolio, which will generateasteadierrevenuestream.

Question 38

ThelendingexperienceofAustralianbanksinthelate1980sandsubsequentupsurgein impairedloansisoftensaidtohaveledtohighstandardsofcreditriskmanagementin recentyears.Discussthelendingpracticesandenvironmentofthelate1980sandhowthis mightdifferinthecurrentclimate.

Answer 38

InAustraliainthe1980s,assetpriceinflation,strongdemandfromcorporateborrowers andincreasedcompetitioninthebankingsectorledbankstoarapidexpansioninlending. Thisexpansionoccurredinearlypost‐deregulationyearswhenbankswereemergingfrom aperiodof‘creditrationing’,thatis,bankswouldallocatealimitedamountoffundsto thelowestriskoptions.Consequently,creditriskmanagementtoolswereverybasic.In addition,bankswereusinglendingtechniquesthathavebeenlargelydiscreditedsince suchasnegativepledgesand‘namelending’.Asweepingchangeinpolicywasforced upon banks when many of these loans failed. The introduction of capital adequacy requirementsin1988,bettercreditriskmanagementskillsandtoolsinADIs,andthe separationofloansalesandcreditanalysisfunctionshaveensuredthatthelending environmentofthe2000shaschangedsignificantly.

Question 39

Conflictsofinterestandopportunitiesforunethicalconductcanariseforlenderswithin thenormalcourseoftheirduties.Identifythreesuchsituationsanddiscusshowthelender shouldrespond.DoestheBankers’CodeofConductprovideappropriatesolutions?

Answer 39

Lenders,particularlythosewhodealdirectlywiththecustomer,cansometimesfind themselvesinapositionwhereaconflictofinterestorthepossibilityofunethicalconduct mayarise.Typicalsituationsmightincludetheofferofavaluablegiftorhospitalityto influencealendingdecision,lendingtoaborrowerwherethelendersownpropertyis beingpurchasedorwhereanopportunitytoinvestcomestothelenderonthestrengthof confidentialinformation.

Question 40

Outlinethedifferentcategoriesofloansthatcompriseimpairedloansandgiveexamples ofeach.

Answer 40

Therearethreetypesofimpairedloans:non‐accrualitems,restructureditemsandother assetsacquiredthroughsecurityenforcement.Atypicalnon‐accrualitemwouldbea mortgageloanwherepaymentisoverdueby90daysandwherethesaleprice,lessthe cost of selling, is less than the principal and accrued interest owed on the loan. A restructureditemmaybeonethatisnotachievingacommercialrateofreturnbecause theloanrepaymentshavebeenreducedduetofinancialdifficultiesexperiencedbythe borrower.Anassetacquiredthroughsecurityenforcementmightbeahousethathas beenrepossessedduetodefaultonamortgageloan.

Question 41

Describethedifferentcategoriesoflendingtothebusinesssector.

Answer 41

Lendingtothebusinesssectorisgenerallydividedintofivecategories.Thesearesmall businesslending,agriculturalloans,corporatelending,projectfinancingandsyndicated loans.Therearesomespecialfeaturesassociatedwitheachofthesetypes.Smallbusiness loans are given to firms that have less than 200 employees. These businesses are dependentonbankfinanceforpurchasingfixedassetsaswellasforworkingcapital needs.Atypicalprobleminsmallbusinessfinancingisthatofover‐trading.Agricultural borrowershavethreemainfinancialneeds;long‐termfinanceforthepurchaseofland; medium‐termfinanceforacquisitionofplantandequipment;andshort‐termfinanceto meetseasonalneeds.Corporatelendingreferstoloansmadetolargecorporations.These includelargepubliccompanies,privatecompaniesandstatutorybodies.Detailedfinancial dataofsuchcorporationsisavailableanditrequiresfinancialexpertisetoanalysethe data.Projectfinancingisresortedtowhenaverylargefinancialinvestmentisinvolved.It istheproject’sownmeritratherthansponsor’sfinancialstrengththatdetermineits viability.Loansyndicationisbasedonthefundamentaltenetofspreadingtheriskandis usuallyusedtofinancemediumtolong‐termprojects.

Question 42

Whatisacommercialbillandwhyhasitbecomeapopularformofshort‐termfinancing?

Answer 42

Acommercialbillisanegotiableinstrumentthatmaybeboughtandsoldinthemarket. Banksmainlyoperatethemarket.Whenusedasaformofcredit,theroleofthebanksis simplytolenditsnametothebilltherebyguaranteeingrepaymentifthecustomer defaults.SupposeAlicebuysgoodsfromBen.ThenAlicecanmakepaymenttoBenin
manyways.Alicecanpaycash(providedshehasitready),paycheque(providedshehas balanceintheaccount);alternatively,shecoulddrawabill,getitendorsedbyherbank andgiveittoBen,whoisreadytoacceptitbecauseifAlicefails,bankwillpayBenafter say3months(maturityofthebill).Effectively,BenhaslentmoneytoAliceonthesecurity ofbank‐endorsedbill.Thusbank’sownmoneyisnottied.Forendorsingthebill,bankwill chargesomefeetoAlice.Itisaconvenientformofshort‐termfinancingandhencehas becomepopular.Otherformslikeoverdraftsareexpensive.

Question 43

Distinguishbetweenaccountsreceivablefinancingandfactoring?

Answer 43

Inaccountsreceivablefinancing,theADIlendsmoneyagainstanagreedpercentageof receivablesthatareassignedtoit.Theborrowingfirmcontinuesitsregularcreditand collectionfunctionsanditscustomersarenotnotifiedoftheassignmentoftheirdebtto thelender. In factoring, a lender actually purchases selected receivables from a borrower at a percentage of face value (discount). The borrower’s customers are notified of the transaction,andallpaymentsaresubsequentlyremitteddirectlytothelender. Thedifferencebetweenthetwomethodsliesmainlyinachangeinownershipofthe receivablesunderfactoringandashiftintheresponsibilityofcollection.Infactoring,the lenderratherthantheborrower,isresponsibleforthecollectionofthereceivables, whereasunderaccountsreceivablefinancing,theborrowermaintainsresponsibilityfor collections.

Question 44

WhatarethedifferenttypesofconsumercreditavailablefromAustralianbanks?

Answer 44

ThedifferenttypesofconsumercreditavailablefromAustralianbanksincludepersonal loans,creditcardloans,marginloansandhomeloans.Homeloansareamajorcategory ofconsumerfinance.Personalloansincludeloansforpurchaseofcarorboat,furniture andotherhouseholditemsincludingaholiday.Creditcardloansrepresentarevolving credit.

Question 45

ExplainthemajorchangesthathavetakenplaceintheAustralianhomeloanmarketin recentyears.

Answer 45

Structural change in the Australian home loan market has been accelerated by technological developments and the emergence of a market for mortgage‐backed securities(MBS).Thesefactorshaveensuredthatnewentrantstothismarkethavebeen abletoaccesscustomersandafundingbasewithouttheneedforatraditionalbranch network,therebyensuringlowdistributioncosts.Newentrantshaveoftenspecialisedin homeloansonly.

Question 46

Enumeratethevariousstepsinvolvedinconsumercreditanalysis.

Answer 46

(a) determineloanpurposeandamount
(b) obtaininformationonconsumercredit,personalfinancialstatementsandincome taxreturns
(c) investigateandverifyinformation
(d) analysefinancialstatementsandcashflow
(e) evaluatecollateralifrequired
(f) priceandstructurethecredit
(g) negotiatewiththeapplicant.

Question 47

‘Electronic methods are providing a cost‐effective alternative to traditional branch banking.’Doyouagree?

Answer 47

Deliveryoffinancialservicescanbeundertakenbywayofautomatedtellermachines (ATMs), electronic funds transfer at point of sale (EFTPOS), telephone banking and Internet banking. The data provided in Table 12.10 of chapter shows the growing importanceofelectronicdeliverymethods.ATMtransactionscostlessthanhalfand EFTPOStransactionscostaroundone‐quarterofover‐the‐countertransactions.These datashowsthatelectronicdeliveryoffinancialservicesisprovingverycost‐effective.