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Commercial and Industrial Lending

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Cost of funds (i.e., 90-day CD rate) plus a markup. ... When market interest rates are changing, average cost could clearly be incorrect. ... – PowerPoint PPT presentation

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Title: Commercial and Industrial Lending


1
Commercial and Industrial Lending
  • Outline
  • The role of asymmetric information in lending
  • The competitive environment
  • The Board of Directors written loan policy
  • Seven ways to make loans
  • Principal lending activities
  • Collateral
  • The lending process

2
The role of asymmetric information in lending
  • Asymmetric information and adverse selection
  • Inequality of information between the lender and
    borrower. Given imperfect information is
    available to lenders, the average interest rate
    is too high for borrowers with low-risk
    investment projects, and too low for borrowers
    with high-risk investment projects.
  • Adverse selection means that high-risk borrowers
    are willing to pay the average rate of interest,
    and low-risk borrowers are not willing to pay it.
    Thus, banks tend to attract higher than average
    borrowers before loans are made.
  • Moral hazard occurs after a loan is made. The
    borrower has an incentive to engage in higher
    risk activities (to earn higher returns) at the
    expense of the bank.
  • Banks must use effective monitoring to reduce
    adverse selection and moral hazard risks.

3
The competitive environment
  • The business of lending
  • Profits on interest income and fee income.
  • Earn higher profits by taking more risk.
  • Credit risk can cause the borrower to default on
    loans causing losses to the bank (i.e., borrower
    has a put option on a loan).
  • Increasing competition
  • Expectation of high returns attracts competition.
  • Banks syndicate loans to compete with investment
    bankers to finance large firms.
  • Nonbank lenders have increased their lending
    activities.
  • Changes in technology
  • Securitization to package and sell otherwise
    unmarketable loans.
  • Credit scoring to estimate the probability a
    borrower will default based on statistical/compute
    r models (e.g., Fair Isaac -- see
    www.fairisaac.com).
  • J.P. Morgan (1997) introduces CreditMetrics, a
    VAR approach to measuring credit portfolio risk.
    Other firms are developing VAR models.

4
The Board of Directors written loan policy
  • The role of Directors
  • Provide guidelines and principles for the banks
    lending activities
  • Loan authority, loan portfolio, geographic
    limits, pricing policies, off-balance sheet
    exposure limits, and loan review process.
  • Reducing credit risk
  • Avoid making high-risk loans.
  • Use collateral to reduce risk (i.e., secondary
    source of payment).
  • Diversify by lending to different types of
    borrowers and avoiding undue concentration to a
    borrower or group of borrowers.
  • Documentation needed to legally enforce a loan
    contract.
  • Guarantees by third parties can reduce risk
    (e.g., the Small Business Administration assists
    small businesses with guarantees).
  • Monitor the behavior of the borrower after the
    loan is made. Agency problems of lender to
    influence the behavior of the borrower.
  • Transfer risk to other parties via securitization
    and loan participations.

5
Seven ways to make loans
  • Banks solicit loans (sales, cross-selling, etc.).
  • Buying loans (participations with other banks --
    when 3 or more unaffiliated banks make a loan in
    excess of 20 million, it is called a shared
    national credit).
  • Loan commitments (an agreement between a bank and
    a firm to lend funds in the future based on
    agreed written terms).
  • Customers request loans.
  • Loan brokers (help arrange loans by approaching
    banks and other lenders with prospective loan
    deals with firms).
  • Overdrafts (that occur when a customer writes a
    check on uncollected funds or there are
    insufficient funds).
  • Refinancing of loans (due to lower loan rates).

6
Principal lending activities
  • Loans and leases for temporary assets versus
    permanent assets
  • Line of credit is a predetermined amount
    available to the firm upon request (under
    established terms and conditions). Normally for
    working capital needs or temporary assets for one
    year or less.
  • Revolving line of credit is a guaranteed maximum
    amount of loans available to the firm. Normally
    for temporary assets but can be for more than 2
    years.
  • Term loan is a single loan for a stated period of
    time, or a series of loans on specified dates.
    Normally for permanent assets (e.g.,, machinery,
    building renovation, refinancing debt, etc.) and
    can be for more than 5 years. Value of loan
    should be less than value of asset, as borrower
    equity is positive (i.e., incentive to pay off
    the loan). Maturity of loan should not exceed
    the life of the asset.
  • Bridge loan helps to finance working capital or
    other needs for a short period of time within
    which the firm is seeking alternative financing
    (e.g., a commercial paper issuance).

7
Principal lending activities
  • Loans and leases for temporary assets versus
    permanent assets
  • Asset-based lending is using the assets of the
    firm to secure a loan. All secured loans can be
    classified as asset-based lending. Unlike
    regular CI loans, greater weight is placed on
    the market value of the collateral. Also,
    greater monitoring of the existence, value, and
    integrity of collateral is performed than for
    other secured loans.
  • Leasing is used to finance tangible assets,
    including cars, airliners, and ships. A lease
    contract enables the user -- lessee -- to secure
    the use of the tangible asset for a specified
    period of time by making payments to the owner --
    lessor. Operating leases are short-term
    contracts, whereas financial leases are long-term
    with terms that equal the economic life of the
    asset.

8
Collateral
  • Definition An asset pledged against the
    performance of an obligation.
  • Does not reduce the risk of the loan per se
    (which is tied to ability of the borrower to
    repay a loan and other factors).
  • Reduces bank risk but increases costs of lending
    and monitoring.
  • Characteristics of good collateral
  • Durability is the ability of the asset to
    withstand wear. Durable versus nondurable
    collateral.
  • Identification due to physical uniqueness or
    serial numbers.
  • Marketability of the property if resold.
  • Stability of value over the period of the loan.
  • Standardization by government or industry
    guidelines in grading quality of assets.

9
Collateral
  • Types of collateral
  • Accounts receivable can be used by means of
  • Pledging wherein the firm retains ownership of
    the receivables and no notification to the buyer
    of the goods.
  • Factoring wherein the receivables are sold to a
    factor such as a bank or finance company. The
    buyer now pays the factor for the goods. Factors
    usually buy receivables on a nonrecourse basis
    (so they cannot be returned to the seller by the
    bank).
  • Bankers acceptance to finance foreign goods in
    transit, which is an account receivable to the
    exporter. A time draft is created which must be
    paid by the importer when goods are finally
    delivered. The time draft becomes a negotiable
    instrument that can be traded in securities
    markets after the importers bank accepts it.
  • Inventory
  • Marketable securities
  • Real property and equipment
  • Guarantees by third parties (e.g., a U.S.
    government agency)

10
The lending process
  • Evaluating a loan request
  • 6 Cs of credit
  • Character (personal traits and attitudes about
    commitment to pay debt)
  • Capacity (borrowers success at running a
    business -- cash flows)
  • Capital (financial condition of the borrower --
    net worth)
  • Collateral (pledged assets)
  • Conditions (economic conditions)
  • Compliance (compliance with laws and regulations,
    such as the Community Reinvestment Act, the
    Environmental Superfund Act, lender liability,
    etc.).
  • Structuring commercial loan agreements
  • Terms of the loan agreement
  • Type of credit facility (e.g., term loan) and
    amount to be borrowed.
  • Term of loan/method of repayment/ interest rates
    and fees/collateral
  • Covenants (promises by the borrower to take or
    not take certain actions during the term of the
    loan)

11
The lending process
  • Pricing commercial loans
  • How to calculate the effective yield
  • The nominal interest rate is the stated rate in
    the loan agreement. The effective yield takes
    into account the payment accrual basis and the
    payment frequency.
  • Payment accrual basis refers to the number of
    days used in the interest rate calculation. For
    example, 365-day year and 360-day year
    calculations (1 million at 10 has a daily
    payment of 273.97 using 365 days versus 277.78
    using 360 days).
  • Number of days outstanding can be actual number
    of days or a 30-day month base.
  • Frequency of interest payments can be monthly,
    quarterly, or annual.

12
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13
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14
The lending process
  • Loan pricing
  • Markups
  • Index rate (i.e., prime rate) plus a markup of
    one or more percentage points.
  • Cost of funds (i.e., 90-day CD rate) plus a
    markup.
  • These methods are simple but may not properly
    account for loan risk, cost of funds, and
    operating expenses.
  • Loan pricing models
  • Return on net funds employed
  • Marginal cost of capital (funds) Profit goal
    (Loan income - Loan expense)/Net bank funds
    employed
  • Here the required rate of return is marginal cost
    of capital (funds) Profit goal. We assume that
    marginal cost of capital equals the weighted
    average cost of capital (WACC) equals 6.
  • The profit goal considers the risk of each loan
    to determine the markup. Assume this equals 2.
  • Loan expense includes all direct and indirect
    costs of the loan but not the banks interest
    cost of funds. Assume 2,000 for labor, etc.
  • Net bank funds employed is the average amount of
    the loan over its life, less funds provided by
    the borrower, net of Fed reserve requirements.
    Assume 100,000.
  • (6 2) (Loan income - 2,000)/100,000
  • Loan income 10,000. Must earn this amount
    to reach the required rate of return.

15
The lending process
  • Relationship pricing
  • Must consider all investment cash flows in the
    loan pricing decision.
  • Minimum spread
  • Compare the lending rate to the cost of funds
    plus a profit margin.
  • Average cost versus marginal cost
  • When market interest rates are changing, average
    cost could clearly be incorrect.
  • If a loan was match funded by issuing CDs, the
    marginal cost is clearly more appropriate.
  • Performance pricing
  • Change the loan rate if the firms riskiness
    changes.
  • Monitoring and loan review
  • Compliance with loan agreement.
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