Types of Borrowers-Lending Process.

A popular way to categorize banks reflects

their orientation to business or individual

borrowers:
1.

Wholesale banks

2.

emphasize business lending

Retail banks

emphasize lending to individuals.

Consumer Loans, SME borrowers, Farmers,
Self Employed, Doctors, Architects, Education
Loans, Housing Loans, Car Loans, Road
Transport Operators, Exporters etc.
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Twin Goals of Lending

The bank does not have the luxury of being

overly selective in the lending process.

There are a limited supply of quality loans.
Hence the bank has two goals in formulating
their lending policy:
1.
2.

Loan Volume
Loan Quality

The bank must balance these with:

Liquidity requirements
Capital constraints
Risk constraints
Return objectives

Trends in competition for loan business

Banks today face tremendous competition for

business they were previously uniquely

qualified for
This has brought about a great deal of
consolidation as banks have attempted to
lower costs and provide a broader base of
services

Increased competition for loans

Although banks have historically been the

primary lenders to business, these businesses

can obtain loans from many different sources
today:
commercial finance companies (AT&T Capital,
Commercial Credit, and GE Capital Corporation),
life insurance companies,
commercial paper, and
the issuance of junk bonds.

Reduced regulation, financial innovation,

increased consumer awareness, and new

technology have made it easier to obtain loans
from a variety of sources.
4

The impact of technology on the banks

lending market
Lending is not just a matter of making the

loan and waiting for payment.

Loans must be monitored and closely

supervised to prevent losses.

Technology advances have meant that more

loans are becoming standardized, hence

easier for market participants to offer in
direct competition to banks.

Technology, loan standardization

and credit scoring
Loans with standard features and uniform

loan applications are more easily packaged

and sold.

The most commonly securitized loans are

those with the most standard features;
mortgages, government-guaranteed student
loans, small business loans sponsored by the
Small Business Administration (SBA), credit
card and auto loans.

Loans with standard features can be offered

by more market participants, hence these

loans often offer the smallest margins.

Many other loans are more difficult to

credit score and securitize.
Not all loans can be standardized, credit

scored and securitized (sold in marketable

packages).

Many farm and small business loans are

designed to meet a specific business need.

Repayment schedules and collateral are often

customized so that they do not conform to some
standard.

Medium to large businesses will have

specialized needs as well.

Not surprisingly this is the area of lending that

is still dominated by commercial banks and the

area in which the bank is uniquely qualified for.
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The credit process

Four Basic steps in the credit process:
1.
2.
3.
4.

Business Development
Credit Analysis
Credit Execution and Administration
Credit Review

Each of these three functions reflect the

banks loan policy.

Loan policy
formalizes lending guidelines that the
employees follow to conduct bank business
It identifies and outlines:

preferred loan qualities; and

establishes procedures for granting,
documenting and reviewing loans

Managements credit philosophy determines

how much risk the bank will take and in what

form

Credit culture

the fundamental principles that drive lending

activity and how management analyzes risk.
There are three potentially different credit

cultures:
1.

Values-driven

2.

Current-profit driven and

3.

focus on credit quality

focus on short term earnings

Market-share driven

focus on having highest market share

10

Business development
Market Research,
Advertising,
Officer call programs, and
Obtaining a formal loan request

11

Credit analysis
Credit analysis is essentially default risk

analysis.
Three areas of commercial risk analysis:
1.
2.
3.

What risks are inherent in the operations of

the business?
What have managers done or failed to do in
mitigating those risks?
How can a lender structure and control its own
risks in supplying funds?

Five C's of Credit:

1. Character 4. Conditions
5. Collateral
2. Capital
3. Capacity

12

Credit execution and administration.

Loan Decision
Individual officer decision
Committee
Centralized underwriting
Loan Agreement (loan package)

Formalizes the purpose of the loan

Terms of the loan
Repayment schedule
Collateral required
Any loan covenants
States what conditions bring about a default

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Documentation
Perfecting the bank's security interest in

collateral

When the bank's claim is superior to that of other

creditors and the borrower

Methods to perfect collateral interest

Require the borrower to sign a security agreement
Obtain title to equipment or vehicle
Insurance (life, equipment, fire and causality)
Loan Covenants

When a bank makes a loan, they in effect put

their profitability and solvency on the line
14

Credit review
Effective credit management separates
loan review from credit analysis
The loan review process can be divided into

two functions:
Monitoring the performance of existing loans.
Handling problem loans.

The loan review committee should act

independent of loan officers and report directly

to the chief executive officer.

15

Characteristics of different types of

credits
Banks try to match credit terms with a

borrower's specific needs.

Long term financing needs are financed with
long term loans.
Short term needs with short term loans.

16

Other loans
Real estate Loans
Agriculture Loans
Consumer Loans

Very different from commercial lending

Usually much less time is required to make
consumer loans
Much smaller amounts

17

Commercial loans
Seasonal Working Capital Loans
Open Credit Lines
Asset Based Loans

Any loan secured by the customers' assets

Leveraged buyouts
Term commercial loans

Typical maturity of 1-7 years

Revolving Credits
Hybrid of short-term working capital loans and
term loans
Roll over working capital loan into a term loan
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Working capital requirements

Net Working Capital

= Current Assets - Current Liabilities

Typically, net working capital is positive
Assets must be financed by:
liabilities or equity

Typically, trade credit current liabilities will

finance a part of a companies current assets
without the need for short term bank credit

19

Working capital cycle

Compares the timing differences between
converting current assets to cash and
making cash payments on obligations
Cash-to-cash cycle

the difference, in days, required for a

company to convert its current assets and
current liabilities into cash
The cash-to-cash cycle essentially measures
how long a firm can receive interest free
financing (trade credit)
Working capital needs = Difference in the cashto-cash cycle times the average daily cost of
goods sold

20

Cash to cash cycle

Days Cash
Days Payable

Days Acct Rec

Days Inventory

Days Accruals
Days Financing

Working Capital Financing needs = deficit times Avg. Daily COGS

21

Working capital cycle for simplex

corporation

22

Cash to cash cycle

Cash-to-cash assets cycle:

Days cash = Cash / Average Daily Sales

Days A/R = AR / Average Daily Sales

Days Inventory = Inventory / Average Daily COGS

Cash-to-cash liability cycle:

Days accounts payable

= AP / Average Daily Purchases
where purchases = COGS + Inventory

Days accrual
= Accrued exps. / Average Daily Oper Exp.

Estimated Working Capital Needs:

= Difference x Average Daily COGS

23

Seasonal versus
permanent working capital needs
Base Amount of W.C.
= Min. Level of Current Assets less min. Level of
Current Liabilities, net of short term bank credit
and Current Maturities of Long Term Debt
(CMLTD).
Some level of current assets / liabilities is

required for any business.

The difference in min. levels represents the
amount of permanent amount of financing.
Base Amount of W.C. should be financed with
Long Term Debt or Equity.
Seasonal W.C. needs
= Total CA - Adjusted Total CL

24

Trends in working capital needs

Total Current Assets

Minimum Current Assets

Total Current Liabilities

Dollars
Minimum Current Liabilities
Total = Permanent Working Capital Needs
+ Seasonal Working Capital Needs
Dollars

Seasonal Working Capital Needs

Permanent Working Capital Needs

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Time

Short-term commercial loans

Banks try to match credit terms with a

borrowers specific needs.
The loan officer estimates the purpose and

amount of the proposed loan, the expected

source of repayment, and the value of
collateral.
The loan amount, maturity, and repayment
schedule are negotiated to coincide with the
projections.
Short-term funding needs are financed by
short-term loans, while long-term needs are
financed by term loans with longer maturities.
26

Seasonal working capital loans.

finance a temporary increase in net current
assets above the permanent requirement
A borrower uses the proceeds to purchase raw

materials and build up inventories of finished

goods in anticipation of later sales.
Trade credit also increases but by a smaller
amount.
Funding requirements persist as the borrower
sells the inventory on credit and accounts
receivables remain outstanding.
The loan declines as the borrower collects on
the receivables and stops accumulating
inventory.
27

Seasonal working capital loans.

this type of loan is seasonal if the need
arises on a regular basis and if the cycle
completes itself within one year
It is self-liquidating in the sense that

repayment derives from sales of the finished

goods that are financed.
Because the loan proceeds finance an increase
in inventories and receivables, banks try to
secure the loan with these assets.
Seasonal working capital loans are often
unsecured because the risk to the lender is
relatively low.
28

Open credit lines

seasonal loans often take the form of
open credit lines.
Under these arrangements, the bank makes a

certain amount of funds available to a borrower for

a set period of time.
The customer determines the timing of actual
borrowings, or takedowns.
Typically, borrowing gradually increases with the
inventory buildup, then declines with the collection
of receivables.
The bank likes to see the loan fully repaid at least
once during each year.

This confirms that the needs are truly seasonal.

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Asset-based loans.

In theory, any loan secured by a companys assets

is an asset-based loan.
One very popular type of asset-based short-term loan

would be those secured by inventories or accounts

receivable.

In the case of inventory loans, the security consists of raw

materials, goods in process, and finished products.
The value of the inventory depends on the marketability of
each component if the borrower goes out of business.
Banks will lend from 40 to 60 percent against raw materials
that are common among businesses and finished goods
that are marketable, and nothing against unfinished
inventory.

With receivables, the security consists of paper assets

that presumably represent sales.

The quality of the collateral depends on the borrowers

integrity in reporting actual sales and the credibility of
billings.

Loans to finance leveraged buyouts are also classified in

this category.

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Highly leveraged transactions.

A leveraged buyout involves a group of

investors, often part of the existing management

team, buying a target company and taking it
private with a minimum amount of equity and
large amount of debt.
Target companies are generally those with
undervalued hard assets.
The investors often sell off specific assets or
subsidiaries to pay down much of the debt
quickly.
If key assets have been undervalued, the
investors may own a downsized company whose
earnings prospects have improved and whose
stock has increased in value.
The investors sell the company or take it public
once the market perceives its greater value.
31

Highly leveraged transactions (HLTs) arise from

three types of transactions:
1. LBOs in which debt is substituted for

privately held equity

2. Leveraged recapitalizations in which
borrowers use loan proceeds to pay large
dividends to shareholders
3. Leveraged acquisitions in which a cash
purchase of another related company
produces an increase in the buyers debt
structure
32

Term commercial loans

Term commercial loans, which have an original

maturity of more than one year, are normally

used for credit needs that persist beyond one
year.
Most term loans have maturities from one to
seven years and are granted to finance either
the purchase of depreciable assets, start-up
costs for a new venture, or a permanent
increase in the level of working capital.
Because repayment comes over several years,
lenders focus more on the borrowers periodic
income and cash flow rather than the balance
sheet.
Term loans often require collateral, but this
represents a secondary source of repayment in
case the borrower defaults.

33

Revolving credits

Revolving credits are a hybrid of short-term working

capital loans and term loans.
They often involve a commitment of funds (the

borrowing base) for one to five years.

At the end of some interim period, the
outstanding principal converts to a term loan.
During the interim period, the borrower
determines usage much like a credit line.
Mandatory principal payments begin once the
commitment converts to a term loan.
The revolver has a fixed maturity and often
requires the borrower to pay a fee at the time
of conversion to a term loan.
Revolvers have often substituted for
commercial paper or corporate bond issues.
34

Consumer loans
Nonmortgage consumer loans differ substantially

from commercial loans.

Their usual purpose is to finance the purchase of
durable goods, although many individuals borrow to
finance education, medical care, and other expenses.
The average loan to each borrower is relatively small.
Most loans have maturities from one to four years,
are repaid in installments, and carry fixed interest
rates.
In general, an individual borrowers default risk is
greater than a commercial customers. Consumer
loan rates are thus higher to compensate for the
greater losses.
35

Consumer loans are normally classified as either

installment, credit card, or noninstallment credit.
Installment loans require a partial payment of

principal plus interest periodically until maturity.

Other consumer loans require either a single
payment of all interest plus principal or a gradual
repayment at the borrowers discretion, as with a
credit line.
Banks share of the consumer credit market has
fallen over time, but even with many competitors,
commercial banks held around 38 percent of the
total credit outstanding in the late 1990s and were
the largest single holders of automobile loans,
mobile home loans, and all other types.
36

Venture capital
a broad term use to describe funding
acquired in the earlier stages of a firms
economic life.
Due to the high leverage and risk involved, as

well as regulatory requirements, banks generally

do not participate directly in venture capital deals.
Some banks, however, do have subsidiaries that
finance certain types of equity participations and
venture capital deals, but their participation is
limited.
This type of funding is usually acquired during
the period in which the company is growing faster
than its ability to generate internal financing and
before the company has achieved the size needed
to be efficient.
37

VC firms attempt to add value to the firm

without taking majority control.
Often, VC firms not only provide financing but

experience, expertise, contacts, and advice when

required.
There are many types of venture financing.

Early stages of financing come in the form seed or startup capital.

These are highly levered transactions in which the VC firm

will lend money for a percentage stake in the firm.
Rarely, if ever, do banks participate as VCs at this stage.

Later-stage development capital takes the form of

expansion and replacement financing, recapitalization or
turnaround financing, buy-out or buy-in financing, and
even mezzanine financing.

Banks do participate in these rounds of financing, but if the

company is overleveraged at the onset, the banks will be
effectively excluded from these later rounds of financing.
38

Conclusion

THANK YOU

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