Canons of Lending

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Canons of Lending

• Lecture Objectives
• 1.      To explain the canons of lending
• 2.  To discuss some significant points in
  commercial banks lending
• 3.      To explain the credit scoring system

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Canons of Lending

• Introduction
• The main interest income of commercial banks is
  derived from granting loans to customers. But
  lending is a risky business. The fundamentals of
  credit are the questions How much money do you
  want to borrow? What do you want the money for?
  How long do you want the money for? And how will
  you repay the money?

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Canons of Lending

• Canons of lending means the general standards or
  the set of principles which any lending
  institutions would follow when processing credit
  facilities for their clients.

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Purpose of the credit

• The borrowing customer has to disclose to his
  banker the object of the borrowing. The bank
  must consider carefully whether the credit is
  most suitable to the borrowers need. The bank
  will then assess whether the loan is to be used
  in any illegal activity or for speculative
  purposes. Most banks will decline loan proposals
  which are highly speculative. The bank is also
  concerned with whether the loan shall generate
  sufficient profit and cash flow desired by both
  the borrower and the banker in order to meet the
  repayment schedule.

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Repayment schedule

• The borrower must be able to service the debt,
  i.e. to pay interest and principal when due. The
  banker will examine, in general, the possible
  sources of income of the borrower, and in
  particular, determine whether there will be
  sufficient cash flow over the term of the loan to
  service the debt.

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Repayment schedule

• To support a loan application, a corporate
  customer is normally required to submit detailed
  financial statements that will substantiate his
  capability to generate adequate funds to repay
  the loan. The financial statements submitted by
  the customer include income statement, balance
  sheet and projection of cash flow and growth of
  the business. The banker will analyze the
  financial position of the borrower to assess the
  repayment capability.

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Amount of the loan

• The amount of the loan requested by the customer
  depends on his business capacity. In order to
  determine the precise amount to be borrowed, the
  banker may examine the corporate customers
  financial statements. They should provide the
  banker with some indications of the customers
  financial position. The bank will examine this
  information in determining the maximum amount to
  be made available to the customer.

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Term of the loan

• The term of the loan is an essential factor in
  assessing credit risk. The longer the term of
  the loan, the higher the risk exposure due to the
  increasing chance of unfavourable long-term
  economic and political changes. In this respect,
  the bank may tailor a loan repayment schedule in
  accordance with the customers financial planning
  and any possible risk. The bank should make some
  judgment on the future course of the economy and
  the political environment so that it is well
  prepared if, in fact, the expected risks
  materialize.

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Credit risk assessment

• Depending on the size of the loan, a banker
  should employ the credit risk assessment in order
  to determine the credit worthiness of potential
  customers.
• (i)    Current risk assessment evaluates
  possible economic and political risks.
• (ii)     Potential risk of default assessment
  involves the evaluation of the risks relating to
  the size of the credit and type of security
  provided by the customers.

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Credit risk assessment

• A bank would issue guidelines to staff
  responsible for loan applications concerning the
  maximum risk the bank should bear for any
  particular type of loan.

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Market analysis

• For commercial loans, whether the customer is
  able to make repayments according to the schedule
  depends largely on the profitability of the goods
  or services produced by the business. If a
  customers product is well received in the
  market, the turnover is likely to generate
  sufficient revenues, resulting in more profit
  available to repay the loan. Therefore, the
  banker must check the economic / market prospect
  of the goods / services the customer is
  producing.

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Market analysis

• In order to understand the operation of the
  borrowing company, the banker will visit the
  production plant or the operation site to make a
  judgment on the borrowers experience, ability
  and integrity in running his business.

13
Pricing of loans

• The bank has to calculate its own costs of
  providing loans to customers. In Hong Kong, most
  banks set the interest rate of loan at some
  percentage (margin) over the prime rate. The
  margin indicates the possible credit risk that a
  loan may bear. The higher the possible risk
  involved, the larger the margin over the prime
  rate to be charged to the loan. It depends on
  the size of the loan, the financial strength of
  the borrower and the nature of security offered
  by the customer.

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Collateral

• Collateral refers to security provided by a
  borrower to offset the apparent weaknesses of a
  loan, such as inadequate capital, certain risks
  and uncertainty arising from market conditions.
  Collateral should be considered as a protection
  rather than as a source of repayment. Collateral
  makes a loan safe but should be the last item to
  be considered in loan approval.

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Character of the borrower

• The character refers to the borrowers
  determination to repay the loan it can be
  assessed by examining his track record. A bank
  can obtain such information from credit card
  companies and other financial institutions. The
  questions to be considered are Are there any
  bank records showing a new customers account
  performance? Is the borrower reliable in making
  repayment according to schedule? Is the borrower
  exaggerating his income or business conditions?

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Capacity

• The capacity indicates a customers ability,
  financial strength and legal capacity to borrow.
  Loans are generally not granted to minors. If
  the customer is a limited company, the bank has
  to examine the companys memorandum and articles
  of association to ensure that it has the legal
  authority to borrow.

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Capital

• The capital is the cushion of assets for
  repayment of the banks advances in the event of
  the borrower experiencing financial difficulties.
  The banker should make sure that the borrower
  has sufficient capital to operate his business
  effectively and to meet keen competition in order
  to maintain his ability to make loan repayment.
  A strong capital base not only demonstrates the
  customers ability to repay his loans but also
  indicates his commitment to sustaining the
  production capability in securing future income.

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Significant points to consider in processing loan
proposals

• It is safer to lend small amounts to many
  customers rather than large amounts to a few
  customers.
• Try to find out as much credit information as
  possible from any sources about the customers.
• Short-term loans bear less risks than long-term
  loans. To protect the bank, always stipulate the
  clause repayment on demand in the terms and
  conditions of the credit.

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Significant points to consider in processing loan
proposals

• Whenever possible, the customers financial
  statements should be obtained and analyzed.
• Make sure that the interest rate agreed with a
  customer reflects the degree of risk involved.
• During the life of a loan, systematic and
  constant reviews of the account should be
  conducted, loan performance and repayment records
  should be carefully monitored.

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Significant points to consider in processing loan
proposals

• Ascertain the value of a security and obtain safe
  title. Verify the genuine ownership of the
  security and make sure that the customer is not
  holding the security merely as a trustee.
• Do not borrow short and lend long. Pay attention
  to the banks liquidity in comparison with the
  loan portfolios.

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Significant points to consider in processing loan
proposals

• Never lend money solely against security even
  though its realizable value exceeds the loan
  amount. Banks are not pawnshops.

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Cross-border Lending

• If a bank decides to provide loans to customers
  in the international market, a country-risk and
  currency-risk assessment should be conducted to
  obtain information about a countrys political
  and economic risks as well as the currencys
  foreign exchange risk. There should be
  appropriate approvals given by the foreign
  government and/or central bank, especially in a
  country of foreign exchange control and there is
  control of ownership in domestic assets which are
  used as security for the loans.

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Credit Scoring System

• Credit scoring is the measurement of the
  statistical probability that credit will be
  repaid. The technique involves awarding points
  to answers given by the prospective borrower to
  the questions listed on an application form. The
  questions cover such areas as

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Credit Scoring System

• (i)      marital status and dependants
• (ii)     age
• (iii)    number of years living at the present
  address
• (iv)   nature of the property occupied, i.e.
  self-owned or rented
• (v)     occupation
• (vi)    length of time with employer
• (vii)   previous credit experience

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Credit Scoring System

• Each question will carry a maximum possible score
  which will be higher for important questions such
  as occupation and lower for less important
  questions such as marital status. The score
  awarded to each answer will vary for example,
  if the question asks for the number of years
  living at the present address, one point might be
  awarded for each year, up to a maximum of 10
  points.

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Credit Scoring System

• The questions are designed by the lending
  specialists of the bank with the guidelines as to
  how the credit staff should interpret the total
  score of an application. If the total score is
  above a certain number, the loan will be granted
  to the applicant.

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Credit Scoring System

• The technique of credit scoring can be used for
  all routine applications for opening a personal
  current account and granting overdraft or
  personal loan. It replaces the personal judgment
  by a scientific method but still most banks will
  carry out other checks, such as a search through
  a credit reference agency.

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Credit Scoring System

• As there is a need for banks to improve the
  accuracy of their credit assessment in view of
  the trend for banks to diversify their customer
  lending portfolio, the HKMA has been considering
  the concept of setting up a credit reference
  agency in Hong Kong. The sharing of credit
  information will enable financial institutions to
  make more informed assessments of their
  customers credit standing, and this should in
  turn improve the asset quality of financial
  institution.

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Before the tutorial

• Visit the library to find the Hong Kong Monthly
  Digest of Statistics and make a copy of the Loans
  and Advances for Use in Hong Kong by Economic
  Sector.
• Discuss the lending situations of all the
  authorized institutions in Hong Kong.