CREDIT ANALYSIS FOR BANK LENDING

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• CREDIT ANALYSIS FOR BANK LENDING

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I. Characteristics of Loan Outstanding by Banks

• Amount Percentage Smallest Largest
• (billion) of Total Loans Banks Banks
• __________________________________________________
  ________________________
• Total Real Estate Loans 1,140 40.5 55.8 35.6
• Loans to Financial Institutions 114.2 4.1 0.1 5.0
  
• Loan to finance agricultural 41.3 1.5 10.9 0.6
• Production and other loans to
• Farmers
• Commercial and industrial loans 709.9 25.2 16.3 2
  7.4
• Loans to individuals 560.9 19.9 15.4 20.7
• Miscellaneous loans 171.7 6.1 1.0 7.4
• Lease finance receivables 78.4 2.8 0.4 3.4
• Total Loans 42,816.3 100 100 100
• __________________________________________________
  ________________________

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I. Characteristics of Loan Outstanding by Banks

• Net Yields on Loans Earned by U.S. Banks
• Gross Yields Deductions for Net Yield
• Types of Loans on each loan Expenses Losses on
  loan
• __________________________________________________
  ____________________________________
• Real Estate Loans
• Smallest banks 9.37 1.46 0.02 7.88
• Medium-sized banks 9.27 1.30 0.08 7.89
• Largest banks 8.94 1..09 0.19 7.66
• Installment Loans
• Smallest banks 10.32 4.43 0.23 5.66
• Medium-sized banks 10.37 4.11 0.44 5.82
• Largest banks 9.75 3.56 0.74 5.45
• Credit Card Loans
• Smallest banks 17.51 22.55 0.71 5.74
• Medium-sized banks 24.33 19.13 2.39 2.82
• Largest banks 24.52 20.53 1.88 2.12
• Commercial and other loans
• Smallest banks 10.04 2.42 0.44 7.17
• Medium-sized banks 9.98 2.69 0.34 6.96

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I. Characteristics of Loan Outstanding by Banks

• Nonperforming Loans as a Percentage of Total
  Loans
• Quarter All Banks lt100m 100n-1b 1b-10b 10b
  
• __________________________________________________
  _____________________
• Commercial Industrial Loans
• December 1995 1.19 1.32 1.23 0.98 1.13
• December 1996 0.98 1.41 1.26 0.91 0.83
• December 1997 0.86 1.26 1.19 0.84 0.71
• December 1998 0.99 1.40 1.24 0.90 0.89
• June 1999 1.11 1.58 1.24 1.03 1.02
• Real Estate Loans
• December 1995 1.39 0.98 1.06 1.18 1.78
• December 1996 1.23 0.94 0.92 1.28 1.40
• December 1997 1.01 0.87 0.77 0.97 1.15
• December 1998 0.91 0.87 0.71 0.84 1.02
• June 1999 0.85 0.87 0.66 0.77 0.95
• Consumer Loans
• December 1995 1.22 0.72 0.64 1.14 1.56
• December 1996 1.36 0.84 0.79 1.42 1.50
• December 1997 1.46 0.86 0.78 1.53 1.62

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II. An Overview on Credit Analysis

• Two goals to make profitable loans with
• minimum risk.
• The two goals should be balanced with the
• banks liquidity requirement, capital adequacy,
• and risk and returns target.
• Strategic planning on business development is
• critical to lending decisions.

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II. An Overview on Credit Analysis

• Three functions in a credit process
• Credit Analysis
• Credit Execution and
  Administration
• Credit Review

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II. An Overview on Credit Analysis

• An Overview of Credit Analysis
• Three distinct areas for a credit analysis
• What risks are inherent in the operations
  of 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 loans?

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II. An Overview on Credit Analysis

• The formal credit analysis procedure
• Collecting information for the credit
  file
• Spreading financial statements
• Ratio Analysis
• Credit Scoring Models
• Projecting the borrowers cash flows
• Evaluating collateral
• Summary Recommendation

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II. An Overview on Credit Analysis

• 2. Credit Execution and Administration
• Loan committee reviews proposal and
  recommendation
• Accept/reject decision made, terms negotiated

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II. An Overview on Credit Analysis

• 2. Credit Execution and Administration
• Establishing a Written Loan Policy
• What should a banks written loan policy contain?
• 1. A goal statement for the banks loan portfolio
  in terms of types, maturities, sizes, and quality
  of loans.
• 2. Specification of the lending authority given
  to each loan officer and loan committee.
• 3. Line of responsibility in making assignments
  and reporting information within the loan
  department.
• 4. Operating procedures for soliciting,
  reviewing, evaluating, and making decisions on
  customer loan applications.
• 5. The required document that is to accompany
  each loan application and what must be kept in
  the banks credit files.

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II. An Overview on Credit Analysis

• 6. Lines of authority within the bank, detailing
  who is responsible for maintaining and reviewing
  the banks credit files.
• 7. Guidelines for taking, evaluating, and
  perfecting loan collateral.
• 8. A presentation of policies and procedures for
  setting loan interest rates and fees and the
  terms for repayment of loans.
• 9. A statement of quality standards applicable to
  al loans.
• 10. A statement of the preferred upper limit for
  total loans outstanding.
• 11. A description of the banks principal trade
  area, from which most loans should come.
• 12. A discussion of the preferred procedures for
  detecting, analyzing, and working out problem
  loan situations.

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II. An Overview on Credit Analysis

• 3. Credit Review
• Credit review is to monitor the performance
• of outstanding loans and to handle problems
• loans
• Scheduled information submission and
• routine check out on the adherence of loan
• covenants are required
• Problem loans workout to be or not to be

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III. Credit Analysis What Makes a Good Loan?

• A. Loan Procedure
• 1. Overview of Management and options
• Characteristics of the business and
• the related industry
• Management quality
• The nature of loan request
• The data quality
• 2. Financial Ratio Analysis
• Liquidity ratios
• Leverage ratios
• Profitability ratios

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II. An Overview on Credit Analysis

• 3. Statement of Cash Flows
• Source and uses of funds
• Source of loan payments
• Timing of cash flows for loan payment
• 4. Financial Projection
• Projecting financial needs of the borrowers
• Projecting cash inflows from the options for
• loan payment
• Determine when all the loan can be repaid

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II. An Overview on Credit Analysis

• B. Financial Analysis
• 1. The 5Cs in Determining Creditworthiness
• Character (good citizen)
• Capacity (cash flow)
• Capital (wealth)
• Collateral (security)
• Conditions(economic, especially
  domestic vulnerability)

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II. An Overview on Credit Analysis

• Quantifying the 5Cs
• Character willing to pay
• - past credit history
• - character reference
• - face-to-face interview
• Capacity measured by take-home pay,
• after-tax profits, or cash flows
• Capital a borrowers net worth position
• Collateral quality of the assets
• Economic Conditions a borrowers
  vulnerability to an economic downturn or credit
  crunch

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II. An Overview on Credit Analysis

• C. Five Cs on Corporate Firms
• Production (measure of capacity and conditions)
• On what production inputs does the applicant
  depend?
• To what extent does this cause supply risk?
• How do input price risks affect the applicant?
• How do costs of production compare with those of
  the competition?
• How does the quality of goods and services
  produced compare with those of the competition?

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II. An Overview on Credit Analysis

• C. Five Cs on Corporate Firms
• Management (measures of character and
  conditions)
• Is management trustworthy?
• Is management skilled at production? Marketing?
  Finance? Building an effective organization?
• To what extent does the company depend on one or
  a few key players?
• Is there a successful plan?
• Are credible and sensible accounting, budgeting,
  and control systems in place?

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II. An Overview on Credit Analysis

• C. Five Cs on Corporate Firms
• Marketing (measures of conditions)
• How are the changing needs of the applicants
  customers likely to affect the applicant?
• How creditworthy are the applicants customers?
• At what stage of their life cycles are the
  applicants products and services?
• What is the applicants marketing policy?
• Who are the applicants competitors? What
  policies are they pursuing? Why are they able to
  remain in business?
• How is the applicant meeting changing market
  needs?

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II. An Overview on Credit Analysis

• C. Five Cs on Corporate Firms
• Capital (measures of capital and collateral)
• How much equity is currently funding the firms
  assets?
• How much access does the firm have to equity and
  debt markets?
• Will the company back the loan with the firms
  assets?

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III. Modeling Credit Risk Analysis

• Credit Risk Factors
• Exogenous factors state of the economy,
• natural disasters, etc
• Endogenous factors managerial
  discretion
• Those endogenous factors reflect managements
  
• philosophy or attitude toward risk-taking

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Beta Analysis

• To identify the bankruptcy risk of a
  corporation
• Seven variables that are good
  discriminators
• between failed or non-failed business
  firms
• - Return on Assets (EBIT/Total Assets)
• - Stability of Earnings (Standard error of
  ROAs)
• - Debt Service (EBIT/Interest Payments)
• - Cumulative Profitability (Retained
• Earnings/Total Assets)
• - Liquidity (Current Assets/Current
  Liability)
• - Capitalization (Market Value of
  Stock/Long-
• term Capital)
• - Size (Total Assets)

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Altmans Multiple Discriminant Analysis

• Z 1.2X1 1.4X2 3.3X3 0.6X4 1.0X5
• Where
• X1 Working Capital/Total Assets
• X2 Retained Earnings/Total Assets
• X3 EBIT/Total Assets
• X4 Market Value of Equity/Book Value of
  Total
• Asset
• X5 Sales/Total Assets
• If Z lt 2.675, assign to the bankrupt group
• If Z ? 2.675, assign to the non bankrupt group
• For 1.81 lt Z lt 2.99 Zone of Ignorance

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Another Scoring Model for Business Loans

• To predict noncompliance with the customers
  original loan agreement.
• Y -2.0434 5.24X1 .0053X2 6.6507X3
  4.4009X4 - .0791 X5 - .1020X6
• Where
• X1 (Cashmarketable securities)/Total Assets
• X2 Net Sales/(Cash Marketable Securities)
• X3 EBIT/Total Assets
• X4 Total Debt/Total Assets
• X5 Fixed Assets/Net Worth
• X6 Working Capital/Net Sales

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Another Scoring Model for Business Loans

• The variable Y is viewed as an index of a
  borrowers propensity for noncompliance and is
  used to calculate the probability of
  noncompliance
• P 1/(1e-y)
• If P gt .50, assign to the noncompliance group
• If P lt .50, assign to the compliance group.

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Consumer Loans

• Duran used the following nine factors to classify
  good loans from bad loans
• Age a score of 0.01 for each year of age over
  20, with a maximum score of .30
• Sex a score of .40 for a female, 0 ot\erwise
• Stability of Residence a score of.042 for each
  year at present residence, with a maximum score
  of .42.

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Consumer Loans

• Industry a score of .21 for those employed in
  utility, government services, and banking and
  brokerage business.
• Stability of Employment a score of .59 for each
  year at employment, with a maximum score of .59
• Three Asset Items A score of .45 for a bank
  account, .35 for real estate, with a maximum for
  life insurance.

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Credit Scoring of a Real Estate Loan

• Characteristic
• Annual gross lt10 10-25 25-50 50
  100 gt 100.000
• Income
•  
• Score 0 15 35 50 75
•  
• TDS gt50 35-50 15-35 5-1 5 lt5
•  
• Score 0 10 20 35 50
• Relations with FI None Checking Savings Both
•  
• Score 0 30 30 60
•  
• Major Credit Cards None 1 or more
• Score 0 20
•  
• Age lt25 25-60 gt60

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Credit Scoring of a Real Estate Loan

• The loan is automatically rejected if the
  applicant's score is less than 120 the loan is
• automatically approved if the total score is
  greater than 190. A score between 120 and 190 is
  reviewed by a loan committee for a final
  decision.
•  
• A loan customer listing the following information
  on the loan application receives the following
  points
•  
• Characteristic Value Score
• __________________________________________________
  _
• Annual gross income 67,000 50
• TDS 12 35
• Relations with FI None 0
• Major credit cards 4 20
• Age 37 30
• Residence Own/mortgage 20
• Length of residence 2 1/2 years 20
• Job stability 2 1/2 years 20
• Credit history Met all payments 50
• Total score 245
•  
• The real estate loan is automatically approved.

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Causes of Problem Loans

• 1. Poor Management Quality
• Lack of depth and diversity in management
  expertise
• Inadequate planning and accounting systems
• Outright fraud
• General incompetence

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Causes of Problem Loans

• 2. Inadequate Initial Capitalization
• Owners underestimate the costs of opening the
  doors for businesses and overestimate the speed
  at which they can turn a profit.
• 3. High Financial and Operating Leverage
• High financial leverage exposes the firm to large
  interest payments even when sales decline.
• High operating leverage exposes the firm to
  substantial depreciation and maintenance expenses
  when sales decline.

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Causes of Problem Loans

• 4. High Sales Growth
• A firms operating problems are accentuated when
  it grows to fast
• Inventory turnover slows
• The collection of receivables slows
• Operating overhead increases
• More assets are needed
• More financing is required.
• A bank must restrict the firms asset growth by
  forcing the firm to collect on sales and monitor
  inventory.

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Causes of Problem Loans

• 5. Strong Competition
• A firm should regularly improve existing
  operations and introduce new products to remain
  competitive.
• A firm could react to competition offensively or
  defensively.
• Companies that do not adapt eventually decay.

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Causes of Problem Loans

• 6. Economic Downturn
• Many firms cannot generate sufficient cash flows
  when the economy slows down, and they do not have
  assets to sell or expenses to cut. The resulting
  strain on cash flows forces firms to rely on
  increased bank borrowing until economic growth
  accelerates.

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20 Common Reasons for Loan Losses

• 1. Collateral overvalued, improperly margined
  failed to get appraisal.
• 2. Dispersal of funds before documentation
  finished.
• 3. Officer making good old boy loans, bypassing
  the loan committee. Personal friendship of loan
  officer with borrower.
• 4. Loan to a new business with an inexperienced
  owner-manager.
• 5. Renewing a loan for increasing amounts, with
  no additional collateral taken.

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20 Common Reasons for Loan Losses

• 6. Repeatedly rewriting loan to cover delinquent
  interest due.
• 7. Not analyzing borrowers cash flows and
  repayment capacity.
• 8. Failure of officer to review loans status
  frequently enough.
• 9. Funds not applied as represented diverted to
  borrowers personal use.
• 10. Funds used out of the banks market area
  poor communications with borrower.

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20 Common Reasons for Loan Losses

• 11. Repayment plan not clear or not stated on the
  face of the note.
• 12. Failure to receive or infrequently receipt of
  borrowers financial statements.
• 13. Failure to realize on collateral because
  borrower raised nuisance legal defenses.
• 14. Bank failure to follow its own written
  policies and procedures.
• 15. Bank president too dominant inpushing through
  loan approval.

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20 Common Reasons for Loan Losses

• 16. Ignoring overdraft situation as a tip-off to
  borrowers major financial problems.
• 17. Failure to inspect borrowers business
  premises.
• 18. Lending against fictitious book net worth of
  business, with no audit or verification of
  borrowers financial statement.
• 19. Failure to get or ignoring negative credit
  bureau reports or other credit references.
• 20 Failure to call loan or to move against
  collateral quickly when deterioration becomes
  obviously hopeless.