Topic 10 - Managing Loans Flashcards
credit philosophy
An ADI must have a clear credit philosophy which incorporates the organisation’s attitude toward risk and determines it’s priorities
credit culture
The ADI has a appropriate credit culture if the behaviour of its staff is closely aligned to its philosophy
The objective of the credit management is to
is to control –minimise –loan losse
ADIs often conduct “autopsies” to determine the reason for a loan loss and prevent a recurrence Common reasons include:
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
The main types of collateral are:
Real property
Personal property in the lender’s possession
Personal property in the borrower’s possession
Real property
a registered mortgage is taken out over land and buildings
Personal property in the lender’s possession
–e.g. shares or cash deposit
Personal property in the borrower’s possession
a charge or equitable mortgage is registered
loan review function
This involves periodically auditing loans and the financial situation of borrowers in order to detect any deterioration in loan quality
Impaired assets are classified as:
Non-accrual loans
Restructured loans
Assets acquired through security enforcement
Non-accrual loans
loans where interest is no longer being paid (typically more than 60 days overdue)
Restructured loans
loans where the terms have been renegotiated because the financial difficulties
Past due loans
where interest payments are overdue –are not technically impaired assets, but are reported due to the risk they represent
The main types of lending are:
- Small business lending
- Agricultural loans
- Corporate lending
- Project financing
- Syndicated loans
The main types of loans are:
- Overdrafts
- Commercial bills
- Term loans
- Third-party credits
- Lease financing
Overdrafts
a company is permitted to overdraw its current account up to a pre-agreed limit
Commercial bills
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
Term loans
This refers to a business loan with a term exceeding one year
Third party credits
Some types of business finance involve contracting with third parties: Guarantees and letters of credit Accounts receivable financing Factoring Inventory financing
Guarantees and letters of credit
A bank will guarantee the payment of funds to a third party or guarantee performance under a contract
Accounts receivable financing
Funds are advanced using accounts receivable as collateral, and the cash flow from the debtorsis used to repay the loan
Factoring
This involves the outright purchase of a customer’s accounts receivable, with the ADI becoming responsible for collection
Inventory financing
Funds are advanced using inventory as collateral, and the cash flow from the sale of inventory is used to repay the loan
Lease financing
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
Lending decisions are based primarily on
The character and soundness of the borrower
The purpose of the loan
The available sources of repayment
Debt/Equity ratio
Total Debt/Total Equity
Interest Coverage Ration
Profit before tax and Interest / Interest Expenses
Average Collectio Period
Accounts Receivable / Sales per day
Inventory Turnover Ratio
Average Cost of Goods Sold / Average Inventory
Consumer lending
refers to loans to householders –i.e. non-business customers
The main types of credit issued to consumers are:
- Personal loans
- Credit cards
- Home loans
Personal loans
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
instalment loan
which has a fixed term and is repaid with periodic payments of interest and principal
ine-of-credit facility
is similar to an overdraft, allowing personal accounts to be overdrawn
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:
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
DiscusswhatismeantbyanADI’screditculture.Howcouldthisbeeffectivelyconveyed withinanorganisation?
AnADI’screditculturecapturestheorganisation’sattitudetoriskinlending.Itexiststo ensure that the credit philosophy and loan policy is appropriately supported and communicatedtoallstaff.Onaday‐to‐daybasisthecreditcultureisstrongifeach individual’sdecisionmakingisconsistentwithmanagementpriorities.
DescribehowanADI’screditphilosophyisreflectedintheriskandreturnoftheloan portfolio.
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.
ThelendingexperienceofAustralianbanksinthelate1980sandsubsequentupsurgein impairedloansisoftensaidtohaveledtohighstandardsofcreditriskmanagementin recentyears.Discussthelendingpracticesandenvironmentofthelate1980sandhowthis mightdifferinthecurrentclimate.
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.
Conflictsofinterestandopportunitiesforunethicalconductcanariseforlenderswithin thenormalcourseoftheirduties.Identifythreesuchsituationsanddiscusshowthelender shouldrespond.DoestheBankers’CodeofConductprovideappropriatesolutions?
Lenders,particularlythosewhodealdirectlywiththecustomer,cansometimesfind themselvesinapositionwhereaconflictofinterestorthepossibilityofunethicalconduct mayarise.Typicalsituationsmightincludetheofferofavaluablegiftorhospitalityto influencealendingdecision,lendingtoaborrowerwherethelendersownpropertyis beingpurchasedorwhereanopportunitytoinvestcomestothelenderonthestrengthof confidentialinformation.
Outlinethedifferentcategoriesofloansthatcompriseimpairedloansandgiveexamples ofeach.
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.
Describethedifferentcategoriesoflendingtothebusinesssector.
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.
Whatisacommercialbillandwhyhasitbecomeapopularformofshort‐termfinancing?
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.
Distinguishbetweenaccountsreceivablefinancingandfactoring?
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.
WhatarethedifferenttypesofconsumercreditavailablefromAustralianbanks?
ThedifferenttypesofconsumercreditavailablefromAustralianbanksincludepersonal loans,creditcardloans,marginloansandhomeloans.Homeloansareamajorcategory ofconsumerfinance.Personalloansincludeloansforpurchaseofcarorboat,furniture andotherhouseholditemsincludingaholiday.Creditcardloansrepresentarevolving credit.
ExplainthemajorchangesthathavetakenplaceintheAustralianhomeloanmarketin recentyears.
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.
Enumeratethevariousstepsinvolvedinconsumercreditanalysis.
(a) determineloanpurposeandamount
(b) obtaininformationonconsumercredit,personalfinancialstatementsandincome taxreturns
(c) investigateandverifyinformation
(d) analysefinancialstatementsandcashflow
(e) evaluatecollateralifrequired
(f) priceandstructurethecredit
(g) negotiatewiththeapplicant.
‘Electronic methods are providing a cost‐effective alternative to traditional branch banking.’Doyouagree?
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.
