Commercial Banking-Exam 3

What are the 5 C's of credit?

Character, Capacity, Capital, Collateral, Conditions

What asset category is the largest at most banks? As of June 30, 2020, __% of industry assets are these.

Loans

52%

Banks in Northwest Arkansas focus on ________ ________ ________ lending due to Walmart vendors need for office space.

Commercial Real Estate

The task of monitoring loan after they are made is referred to as ____ _____. Who carries this out?

Loan review

Loan comittee

What are the four steps of the lending process?

1. Find prospective loan customers

2. Evaluate their creditworthiness

3. Structure the loan

4. Monitor the loan

5 C's of Credit:

Integrity of the borrower?

Character

5 C's of Credit:

Skin in the game

Capital

Projected cash flow of the project

Capacity

Assets to serve as a back-up form of repayment

Collateral

Cyclical component of credit risk

Conditions

In additon to real estate, loans can be collateralized by ______ ______, _______, personal _______, and personal ________ from the owners.

1. Accounts receivable

2. Inventory

3. Property

4. Guarantees

What is the most important consideration when a bank is considering making a loan?

Interest rate

Commercial and industrial loans typically have _______ rates while real esate loans are more likely to have ____ rates.

Floating

Fixed

Loans that have only periodic interest payments, and the principal is paid at maturity.

Bullet loans

Loan commitments typically have ______ balances while direct loans have _____ balances.

Revolving

Fixed

Loan contracts may require _______, which require compliance with certain directives.

Covenants

A bank must grade its loans using the same classification system as the bank examiners.

True/False

False

A bank examiner will review a sample of loans during a bank exam and "classify" each loan. Which of these loan grades are considered adversely classified?

a.) Loss

b.) Substandard

c.) Pass

d.) Special Mention

e.) Doubtful

a.) Loss

b.) Substandard

c.) Doubtful

The purpose of the loan review process is to:

a.) assess adherence to the bank's internal loan policies

b.) evaluate the effectiveness of its lending personnel

c.) identify loans with potential credit weakness

d.) all these answers are correct

d.) all these answers are correct

What are the 5 supervisory loan grades?

Pass, Special Mention, Substandard, Doubtful, Loss

Which term matches the supervisory loan grade?

No material problems.

Pass

Which term matches the supervisory loan grade?

Some weakness exists that can be corrected in the normal course of business.

Special Mention

Which term matches the supervisory loan grade?

A well defined weakness exists.

Substandard

Which term matches the supervisory loan grade?

At least some of the loan will not be repaid in full but the amount of loss is unknown.

Doubtful

Which term matches the supervisory loan grade?

A specific portion of the loan is uncollectible and must be written off immediately.

Loss

A bank has a loan outstanding to a customer for $750,000. The customer is having cash flow difficulties, and the bank perceives that the likelihood of full repayment is low. The collateral value backing the loan is $250,000, so there will be some, but certainly not complete, loss in the loan. At this time, the bank does not know the projected loss amount. The bank grades $250,000 of the loan as substandard because at least that portion of the loan is likely to be repaid. The rest of the loan balance ($500,000) is best graded as?

a.) Doubtful

b.) Special Mention

c.) Substandard

d.) Loss

a.) Doubtful

Which of the Five C's match the descrpition?

Checks the net worth of the potential borrower to ensure that they have $1 million to invest in the business as promised.

Capital

Which of the Five C's match the descrpition?

Checks the credit history of the borrower looking for any previous loan defaults and experience managing commercial property, and contacts references.

Character

Which of the Five C's match the descrpition?

Orders an appraisal of the property.

Collateral

Which of the Five C's match the descrpition?

Checks the applicant's projected statement of cash flow.

Capacity

Which of the Five C's match the descrpition?

Checks the recent trends in the occupancy rates of retail real estate.

Conditions

A bank has a loan outstanding to a customer of $600,000. The business is shut down and no more payments from the borrower are expected. The equipment, which serves as the collateral, has just been liquidated at auction for $300,000. The $300,000 portion of the loan not covered by collateral is best graded as:

a.) Substandard

b.) Special Mention

c.) Loss

d.) Doubtful

c.) Loss

A bank has a loan outstanding to a customer for $300,000. The customer has not made a payment in several months and the bank no longer expects additonal payments. The borrower's house (which is fully paid off) is used as collateral for the loan and it has been recently appraised at $400,000. The bank should grade the $300,000 loan as:

a.) Doubtful

b.) Pass

c.) Substandard

d.) Loss

c.) Substandard

Generally, the chief loan officer should head the bank's loan review committee because that individual knows more about the loans than anyone else in the bank.

True/False

False

A bank has a line of credit outstanding to a customer for $1.1 million, of which $200,000 is currently drawn. The customer is a small business owner that sells designer shoes. She has yet to miss a payment, but she recently spoke to the bank about a decline in sales that she thinks is due to some poor purchasing decisions of items that customers are not eager to buy. She will drawn down the line of credit temporarily to be able to sell the shoes at a steep discount. She is very excited about the new inventory coming to the store. This loan is best graded as:

a.)Loss

b.) Doubtful

c.) Substandard

d.) Special Mention

d.) Special Mention

What are the three major categories of business loans?

1. Commercial Real Estate

2. Commercial & Industrial

3. Farm (Agricultural)

What are the three ratios to measure liquidity?

1. Current Ratio

2. Working Capital

3. Quick (acid test) Ratio

What is the current ratio equation? What does it assess?

(Current assets/Current liabilities)

Firm's short-term access to cash

What is the working capital equation? What does it assess?

Current assets - Current Liabilities

Dollar amrount of liquidity cushion between short-term assets and liabilites

What is the quick (acid test) ratio equation? What does it assess?

((Current assets - Inventory) / Current liabilities )

Narrower measure of short-term liquidity than the current ratio. Industry benchmark is 1.0x

What are the three financial leverage ratios?

1. Debt-to-net worth ratio

2. Tangible leverage ratio

3. Tangible effective leverage ratio

What do the financial leverage ratios measure?

Firm's reliance on debt rather than equity to finance its operations.

Higher leverage indicates ______ debt?

Higher

If debt becomes too high, the ______ of the firm may be threatened.

Solvency

What is solvency?

Ability to pay debts

What do profitability ratios measure?

Earning power of the company

What are the profitability ratios?

1. Gross profit margin

2. Operating profit margin

3. Pretax profit margin

4. Net profit margin

5. Return on Assets

6. Return on Equity

What two things do efficiency ratios measure?

1. Firm's operational efficiency

2. Manage inventory and collect revenues

What are the four efficiency ratios?

1. Accounts Receivable Turnover

2. Accounts Payable Turnover

3. Inventory Turnover

4. Sales to Assets

What do coverage ratios measure?

Ability of firm to meet debt payments with cash flow.

Of the Five C's, coverage ratios are closes to ______.

Capacity

What are the four coverage ratios?

1. Traditional cash flow

2. Fixed charge coverage ratio

3. Interest coverage ratio

4. Dividend payout ratio

What is a cash flow statement? What period does it usually cover?

Tracks sources and uses of cash.

Usually a period of one year.

What three categories are cash flows broken into?

1. Operations

2. Investing

3. Financing

The primary emphasis of a bank lender's assessment of credit risk of a large and established business is on quantifiable analysis of the business rather than character.

True/False

True

It is important for a firm to have an interest coverage ratio less than 1 so that it can at least make its interest payments in a timely manner.

True/False

False

A loan that gives a customer the right to borrow up to a maximum amount over a certain time frame and repay and reborrow as often as necessary is called a(n)

a.) working capital loan

b.) interim construction loan

c.) revolving credit line

d.) second mortgage

C

A firm is more highly leveraged when its ratio of liabilities to net worth is low rather than high.

True/False

False

A firm is operating more efficiently when its accounts receivable turnover and inventory turnover are rising.

True/False

False

It is important for a firm to have a fixed charge (principal and interest) coverage ratio above 1 so that it can at least make its interest and principal payments in a timely manner.

True/False

True

Match each financial item with the correct business creditworthiness category.

Questions: Liabilities to equity, Inventory turnover, Profit margin, Interest coverage, Working capital

Matches:

Leverage

Operating efficiency

Profitability

Debt coverage

Liquidity

Liabilities to Equity = Leverage

Inventory Turnover = Operating Efficiency

Profit Margin = Profitability

Interest Coverage = Debt Coverage

Working Capital = Liquidity

A bank makes a business loan to an existing restaurant secured by a personal guarantee from the owners. How is this loan classified?

a) Farmland

b) Construction and Land Development

c) Nonfarm nonresidential

d) Commercial and Industrial

e) Multifamily

d) Commercial and Industrial

A bank makes a business loan to a firm to build a new hotel, and the loan is secured by the hotel. How is this loan classified?

a) Construction and Land Development

b) Nonfarm nonresidential

c) Farmland

d) Commercial and Industrial

e) Multifamily

a) Construction and Land Development

Cash flow from financing activities is the portion of net cash:

a) generated from the firm's income and working capital

b) generated from buying or selling assets

c) generated from net issuance of debt and equity

d) none of the above

c) generated from net issuance of debt and equity

All else equal, a manufacturing firm's leverage is increasing if its:

a) all these answers are correct

b) reduces net income

c) is added back to cash flow because it is a noncash expense

d) occurs when the deterioration of a long-lived asset is recognized through time

a) all these answers are correct

A loan to a chicken farm to purchase raw materials is secured by the farm's property. This loan is classified as a farmland loan.

True/False

True

A firm has net profit of $20, interest expense of $15, taxes of $4, and deprecaition expense of $7. It also has $30 of long-term debt maturing in the current year. What is the firm's traditional coverage ratio? Enter your answer with one decimal using no formatting or symbols.

0.8

All else equal, depreciation expense:

a) reduces net income

b) all these answers are correct

c) is added back to cash flow because it is a noncash expense

d) occurs when the deterioration of a long-lived asset is recognized through time

b) all these answers are correct

A bank makes a business loan to the owner of a hotel to provide liquidity to help the firm through a period of low occupancy due to the pandemic. The loan is secured by the hotel. How is this loan classified?

a) Nonfarm nonresidential

b) Commercial and Industrial

c) Multifamily

d) Construction and Land Development

e) Farmland

a) Nonfarm nonresidential

A firm has net profit of $20, interest expense of $15, taxes of $4, and deprecaition expense of $7. It also has $30 of long-term debt maturing in the current year. What is the firm's traditional coverage ratio? Enter your answer with one decimal using no formatting or symbols.

0.9

A firm has net profit of $23, interest expense of $12, taxes of $2, and deprecaition expense of $4. It also has $29 of long-term debt maturing in the current year. What is the firm's interest coverage ratio? Round your answer to one decimal with no formatting or symbols.

3.1

What are the two distinct categories of consumer loans?

1. Loans to individuals

2. 1-4 family residential mortgage

Loans to Individuals are secured by real estate.

True/False

False, they are NOT

What are residential mortgage loans secured by?

Residential buildings with up to four units.

What is a property with 5 or more units considered? Where in the bank's portfolio is it found?

Multifamily loan, which is part of a bank's commercial real estate portfolio.

What is HELOC stand for? What is it?

Home Equity Line of Credit

Revolving credit line secured by the owner's equity in the 1-4 family property.

What are the two types of liens in residential mortgages?

1. First

2. Junior

What is the difference between a first lien and a junior lien?

First lien:

-Senior loan that has priority in foreclosure proceedings.

-Receives payment of principal and interest in full before junior receives anything.

Scale economies are not nearly as important in mortgage lending as they are in credit card lending.

True/False

Why? Two factors.

True.

1. Personal relationships are more important

2. Scale economies in mortgage lending do exist, but only in loan origination stage

What is securitization?

The process of transforming financial assets into marketable securities

Walk through the four step process of Mortgage Securitization:

1. Homeowner finances home purchase through bank

2. Bank sells that loan to GSE (Fannie Mae/Freddie Mac)

3. GSEs securitize loans and convert them into MBS (mortgage backed securities)

4. Investors purchase those MBS securities

Who among is interest income from securitization divided?

Among banks, GSEs, and MBS investors.

A newly originated mortgage contains three types of risk:

1. Credit risk

2. Liquidity risk

3. Interest rate risk

Match the risks with institutions:

a.) Interest Rate, Liquidity, Credit

b.) Banks, GSEs, MBS investors

Bank = Liquidity Risk (At first)

GSEs = Credit Risk

MBS Investors = Interest Rate Risk, Liquidity (Last)

Of all the bank loan types, loans to individuals, are the _____ costly to originate and have the ______ average default rates.

Why?

Most, Highest

Most people rely on one income

What are the three top credit bureaus?

Equifax, Experian, and TransUnion

What does the Fair and Accurate Credit Transactions Act (FACTA) of 2003 allow consumers to do?

Obtain one free credit report every 12 months from each of the three top bureaus. (AnnualCreditReport.com)

How long does it take for a Chapter 7 & 13 Bankruptcy until it must be removed from a credit report?

What about Foreclosures?

Chap 7: 10 yrs

Chap 13: 7 yrs

Foreclosure: 7 yrs

What does a credit report NOT include? (six of them)

1. Income

2. Race

3. Gender

4. Sexuality

5. Marital Status

6. Credit Score

A credit score is a single number that estimates a consumer's likelihood to:

Repay a loan in full as reflected by credit score

What is the most popular credit scoring model?

What is it property of?

FICO

Fair Issac Corporation

A consumer is considered a prime borrower if their FICO score is ___ or higher?

670

What are the five categories for FICO Credit Scores?

1. Payment history

2. Amounts owed

3. Length of credit history

4. New credit

5. Credit mix

What are the weights of the FICO Credit scores?

1. Payment history

2. Amounts owed

3. Length of credit history

4. New credit

5. Credit mix

1. Payment history (35%)

2. Amounts owed (30%)

3. Length of credit history (15%)

4. New credit (10%)

5. Credit mix (10%)

Borrowers that diversify their credit types have _____ scores.

Higher

What is the agency responsible implementing and enforcing federal consumer financial laws?

Consumer Financial Protection Bureau (CFPB)

What created the Consumer Financial Protection Bureau (CFPB)?

Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010

The Consumer Financial Protection Bureau (CFPB) is the primary consumer compliance supervisor for depositry institutions with more than $__ billion in assets.

$10B

Consumer compliance at the three federal banking regulators (OCC, Fed Reserve, and FDIC) supervise banks with _____ than $10B in assets.

Fewer

Which act mandates that lenders disclose to the borrower important credit terms before the borrower commits to pay the loan?

Truth in Lending Act of 1968