What are the principal types of loans made by banks?

What should a good written bank loan policy contain? Explain the meaning of the following terms: character, capacity, cash, collateral, conditions, and control? 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, and agricultural production loans Bank loans may also be classified by maturity - over one year and one year or less. A good written bank loan policy should specify the goals of the bank's loan portfolio and program, describe an ideal loan portfolio for the bank and indicate the types of loans the bank normally will refuse to make, specify who has the authority to approve loans of varying type and size, the documentation requirements of different types of loans, and supply guidelines on loan pricing and collateralization for loan officers. a.Character -- is the borrower serious about the purpose of a loan and intends to repay? b.Capacity -- does the borrower have the legal authority to sign and commit to a binding loan agreement? c.Capital -- does the borrower generate sufficient income or cash flow to properly service a loan? d.Collateral -- does the borrower possess assets of sufficient quality and value to backstop a loan? e.Conditions - does the outlook for the economy and industry where a borrower is situated add strength to loan? f.Control -- does the proposed loan meet the bank's own quality standards and the standards of bank examiners? What is loan review? How should a loan review be conducted? What are some warning signs to bank management that a problem loan may be developing? What steps should a banker go through in trying to resolve a problem loan situation? Loan review is a process of periodic investigation of outstanding loans on a bank'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. While banks today use a variety of different loan review procedures, a few general procedures are followed by nearly all banks. These include: 1. 2. 3. 4. 5. 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.

Loan review is not a luxury but a necessity for a sound bank lending program. It not only helps management spot problem loans more quickly but also acts as a continuing check on whether loan officers are adhering to a bank's loan policy. For this reason, as well as to promote objectivity in the loan review process, many of the largest banks separate their loan review personnel from the loan department itself. Loan reviews also aid senior management and the bank's board of directors in assessing the bank's overall exposure to risk and its possible need for more capital in the future. Problem loans are often characterized by reduced communication between borrower and lender, delays in receiving financial reports, evidence of reevaluations of assets (such as inventory or pension-plan assets), declining stock prices, changes in management, or the restructuring of other loans the borrower has taken out. The most important first step is to move quickly to contact the borrower, to ascertain if the borrower understands the nature of the loan problem, to explore for creative solutions to the problem, and to get the borrower to reach a decision on the best solution possible. What special problems does business lending present to the management of a bank? What are the essential differences among working capital loans, open credit lines, asset-based loans, term loans, revolving credit lines, interim financing, project loans, and acquisition loans? While business loans are usually considered among the safest types of bank lending (their default rate, for example, is usually well below default rates on most other types of loans), these loans average much larger in dollar volume than other bank loans and, therefore, can subject a bank to excessive risk of loss and, if a substantial number of loans fail, can lead to the failure of a bank. Moreover, business loans are usually much more complex financial deals than most other kinds of bank loans, requiring larger numbers of bank personnel with special skills and knowledge. These additional resources required increase the magnitude of potential loss to a bank unless it manages its business loan portfolio with great care and skill. Working Capital Loans -- Loans to fund the current assets of a business, such as accounts receivable, inventories, or to replenish cash. Open Credit Lines -- A credit agreement allowing a business to borrow up to a specified maximum amount of credit at any time until the point in time when the credit line expires.

Asset-based Loans -- Credit whose amount and timing is based directly upon the value, condition, and maturity of certain assets held by a business firm (such as accounts receivable or inventory) with those assets usually being pledged as collateral behind the loan. Term Loans -- Business loans that have an original maturity of more than one year and normally are used to fund the purchase of new plant and equipment or to provide for a permanent increase in working capital. Revolving Credit Lines -- Lines of credit that promise the business borrower access to any amount of borrowed funds up to a specified maximum amount; moreover, the customer may borrow, repay, and borrow again any number of times until the credit line reaches its maturity date. Interim Financing -- Bank funding to start construction or to complete construction of a business project in the form of a short-term loan; once the project is completed, long-term funding will normally pay off and replace the interim financing. Project Loans -- Credit to support the start up of a new business project, such as the construction of an offshore drilling platform or the installation of a new warehouse or assembly line; often such loans are secured by the property or equipment that are part of the new project. Acquisition Loans--Loans to finance mergers and acquisitions of businesses. Among the most noteworthy of these acquisition credits are leveraged buyouts of firms by small groups of investors. What aspects of a business firm's financial statements do bank loan officers and credit analysts examine carefully and what are the key rations in each? Outline the problems with employing ratio measures of business performance. Bank loan officers and credit analysts examine the following aspects of a business firm's financial statements: Control Over Expenses? Key ratios here include cost of goods sold/net sales; selling, administrative and other expenses/net sales; wages and salaries/net sales; and interest expenses on borrowed funds/net sales. Activity or Efficiency? Important ratios here are net sales/total assets, and fixed assets, accounts and notes receivable, and cost-ofgoods sold divided by average inventory levels. Marketability of a Product, Service, or Skill? Key ratio measures in this area are the gross profit margin, or net sales less cost of goods sold to net sales, and the net profit margin, or net income after taxes to net sales. Coverage? Important measures here include interest coverage (such as before-tax income and interest payments divided by total interest payments), coverage of interest and principal payments (such as earnings before interest and taxes divided by annual interest payments plus principal payments adjusted for the tax effect), and the coverage of all fixed payments (such as before-tax income plus interest payments plus lease payments divided by interest payments plus lease payments). Profitability Indicators? Key barometers in this area can include such ratios as before-tax net income divided by total assets, net worth, or sales, and after-tax net income divided by total assets, net worth, or total sales. Liquidity Indicators? Important ratio measures here usually include the current ratio (current assets divided by current liabilities), and the acid-test liquidity ratio (current assets less inventories divided by current liabilities). Leverage indicators? Ratios indicating trends in this dimension of business performance usually include the leverage ratio (total liabilities/total assets or net worth), the capitalization ratio (of long-term debt divided by total long-term liabilities and net worth), and the debt-to-sales ratio (of total liabilities divided by net sales). One problem with employing ratio measures of business performance is that they only reflect symptoms of a possible problem but usually don't tell us the nature of the problem or its causes. Management must look much more deeply into the reasons behind any apparent trend in a ratio. Moreover, any time the value of a ratio changes, that change could be due to a shift in the numerator of the ratio, in the denominator, or both. What are contingent liabilities and why might they be important in deciding whether to approve or disapprove a business loan request? How can a Sources and Uses of Funds Statement aid a bank in making the decision to grant or deny a business loan request? Contingent liabilities include such pending or possible future obligations as lawsuits against a business firm, and warranties or guarantees the firm has given to others regarding the quality, safety, or performance of its product or service . Another example is a credit guaranty in which the firm may have pledged its assets or credit to back up the borrowings of another business, such as a subsidiary. Environmental damage caused by a business borrower also has recently become of great concern as a contingent liability for many banks because a bank foreclosing on business property for nonpayment of a loan could become liable for cleanup costs, especially if the bank becomes significantly involved with a customer's business or treats foreclosed property as an investment rather than a repossessed asset that is quickly liquidated to recover the unpaid balance on a loan. Loan officers must be aware of all contingent liabilities because any or all of them could become due and payable claims against the business borrower, weakening the firm's ability to repay its loan to the bank. A sources-and-uses-of-funds statement shows the changes in a business firm's assets and liabilities as well as its flow of net profit and noncash expenses (such as depreciation) over a specific time period. It shows where the firm raised its operating capital during the time period under examination and how it spent or used those funds in acquiring assets or paying down liabilities. From the perspective of a loan officer the sources-and-uses statement indicates whether the firm is relying heavily upon borrowed funds and

sales of assets. These are two less desirable funding sources from the point of view of a bank lending money to a business firm. In contrast, bank loan officers usually prefer to focus upon cash flow - whether the firm is generating sufficient cash flow (net income plus noncash expenses) to repay most of its debt. What methods are in use today to price business loans? What are their principal strengths and weaknesses reflected in the way they are used today? The following methods are in use today to price business loans: a. b. c. Cost-plus pricing Price leadership pricing model Markup market-pricing model d. e. CAP rate Customer Profitability Analysis

Cost-plus-profit pricing requires the bank to estimate the total cost involved in making a loan and then adds to that cost estimate a small margin for profit. The price-leadership model, on the other hand, bases the loan rate upon a national or international rate (such as prime or LIBOR) posted by major banks and then adds a small increment on top for profit or risk. The markup model prices a loan on the basis of cost plus a risk premium added to those loans with greater credit risk and/or longer term loans that have greater term risk. CAP rates specify a maximum rate that a borrower can be assessed, thus limiting a borrower's interest-rate risk. Customer profitability analysis looks at all the revenues and costs involved in serving a customer and then requires the bank to calculate the net rate of return from this particular customer. a. Cost-plus pricing

Strength: considers the cost of raising loanable funds and operating costs of running the bank. Weaknesses: banks must know what their costs are in order to consistently make profitable, correctly priced loans; gives little regard to competition from other lenders. b. Price leadership pricing model

Strength: considers competition from other lenders, allows for a risk premium to be added to the base or prime rate. Weakness: does not consider the marginal cost of raising loanable funds. c. Markup market-pricing model

Strength: allows banks to compete more aggressively with the commercial paper market. Weakness: narrow margins (markups) on loans. d. CAP rate

Strength: is another service option that a bank may offer its customers for a specific fee. Weakness: a prolonged period of high interest rates will effectively transfer the risk of fluctuating interest rates from borrower to lender. e. Customer profitability analysis takes the whole customer relationship into account when pricing each loan request. must consider revenues and expenses from all of the bank's dealings with the customer.

Strength: Weakness:

What are the principal differences among residential loans, nonresidential installment loans, noninstallment loans, and credit card loans? Why do interest rates on consumer loans typically average higher than on most other kinds of bank loans? How do credit scoring systems work? What are the principal advantages to a bank of using a credit scoring system to evaluate consumer loan applications? Are there any significant disadvantages to a credit scoring system? Residential loans are credit to finance the purchase of a home or fund improvements on a private residence. Installment loans are paid off gradually over time whereas noninstallment loans are generally paid off in lump sum at the end of the loan. Installment loans usually finance large-volume purchases, such as automobiles or household furniture, whereas noninstallment loans usually are directed at current living expenses. Installment loans help the bank recover funds that can be reloaned more quickly but they generally

require a more intensive credit investigation by the bank. Bank credit cards offer convenience and a revolving line of credit that the customer can access whenever the need arises. Interest rates on consumer loans are typically higher than on most other kinds of bank loans since they are among the most costly and most risky to make per dollar of loanable funds. Consumer loans also tend to be cyclically sensitive. Moreover, consumers tend to be relatively unresponsive to changes in interest rates when they go out and borrow money. Credit-scoring systems use statistical techniques (usually multiple discriminant analysis) to classify borrowers based on selected characteristics of each borrower as to whether they are likely or unlikely to repay the loan they have requested. The credit scoring method has the advantage of being objective, requiring less loan officer judgement, possibly lowering loan losses, and lowering operating costs when a large volume of consumer loans is processed. Credit scoring systems do not take into account motivational factors or individual differences and may become outdated unless frequently retested for statistical accuracy. John Crazy has asked for a $3500 loan from GU bank to repay some personal expenses. The bank uses a credit scoring system to evaluate such requests, which contains the following factors: Credit Rating (excellent = 3; average = 2, poor or no record = 0) Time in current job (5 years or more = 6, one to five years = 3) Time at current residence (more than 2 years = 4; one to two years = 2; less than one year = 1) Telephone in residence (yes = 1; no = 0) Holds an account at the Bank (yes = 2; no = 0) The bank generally grants a loan if a customer scores 9 or more points. Mr. Crazy has an average credit rating, has been in his current job for 3 years, has been at his current residence for 2 years, has a telephone but has no account at the bank. As a trainee at the bank would you grant Mr Crazy acceptance for his loan application? 2+3+2+1+0= 8 NO Suppose a customer is offered a loan at a discount rate of 8 percent and pays $75 in interest at the beginning of the term of the loan. What net amount of credit did this customer receive? Suppose you are told that the effective rate on this loan is 12 percent. What is the average loan amount the customer had available during the year? The relevant formula is: Discount loan rate = Interest Owed Net Amount of Credit Received = $75 x = 0.08

Then the net amount of credit received must be $75/.08 or $937.50. In this instance: Effective loan ratio = Interest Owed Average Loan Amount During the Year = $75 x = 0.12

Then the average loan amount during the year must be: x = $75 = $625. 0.12

As a credit trainee you have been asked to evaluate the financial position of UOL Corporation, applying for renewal and increase in its 6-month line of credit to $7 million. The Sources and Uses of Funds Statement for UOL would appear as follows:

Sources and Uses for the Coming Year S & U Item Source Use Cash Account $115 Accounts Rec. $207 Inventories $79 Net Fixed Assets $158 Other Assets $21 Totals $115 $465

Sources and Uses for the Coming Year S & U Item Source Use Accounts Pay. $60 Notes Payable $217 Taxes Payable $111 Long Term Debt $59 Common Stock Undivided Profits $125 Totals $461 $111

Assess whether UOL Should be granted a business loan and what areas cause concern to you as a lending officer. What Additional information that would be desirable and helpful, if not essential to help you in your decision making. The figures given in the case as well as the supporting background information suggest several developing problems. Hamilton has had a recent shakeup in its senior management, which usually leads to looser control of the firm until the new management gains sufficient experience. Among the obvious problems are a decline in sales (from $48.1 million to $39.7 million) in the past six months. Hamilton's cost of goods sold dropped but by less than the decline in sales, thereby squeezing the firm's margin and net income. We note too that the firm, faced with declining cash flows, has been forced to rely more heavily on borrowings which will mean that the bank's position will be less secure. Current assets have also declined while current liabilities are on the rise, thus reducing the firm's net liquidity position. The bank's relationship with Hamilton needs to be reviewed carefully with an eye to gaining additional collateral or reducing the bank's total credit commitment to the firm. Alternative Scenario 1: Given: Sales, cost of goods sold, and selling and administrative expenses grew an average of one percent per month over the past six months. Solution: The growth in sales would be a definite improvement over the base case where sales declined each month. Of course, the growth in cost of goods sold, which would be expected, dilutes some of the increase in revenues, as does the growth in selling and administrative expenses. However, overall, Hamilton's operating income (and cash flow) position would be improved with the average one percent per month growth situation. In the base case, Hamilton's EBIDT (Earnings Before Interest, Depreciation and Taxes) for June, for example, is -$ 2.2 million. Whereas, with the one percent per month growth, Hamilton's EBIDT for June would be $ 1.16 million. Alternative Scenario 2: Given: Current ratio rose gradually between January and June from 1.0 to 1.5, with current assets rising from $ 7 million to $ 9 million. Solution: A current ration of 1.0 with current assets of $ 7 million means that current liabilities are also $ 7 million. A current ratio of 1.5 (in June) with current assets of $ 9 million means that current liabilities are then $ 6 million. The improved current ratio of 1.5 would be considered much better, particularly with the decline in current liabilities. This should improve the credit analyst's opinion of the loan request. Alternative Scenario 3: Given: Hamilton is seasonal with strong rebound in sales in summer and fall.

Solution: Knowing that the business is seasonal with improved performance in subsequent months would likely improve our outlook for this loan. Additional information that would be desirable and helpful, if not essential, should include: 1) 2) 3) 4) Past financial statements for the last two or three years, preferably on a monthly basis. This could help us verify seasonality and improvement. Industry outlook for the next six to eighteen months would also help in reinforcing Hamilton's ability to service the debt from the summer and fall cash flows. Additionally, information about the company's suppliers, other creditors, customers, and competitors would be helpful. Also, more information about other relationships that Hamilton has with Evergreen would certainly be helpful.

In summary, the more information we have, the better our analysis and subsequent decisions will be.