Chap 1-Sathye

INTRODUCTION

  • Understanding the principles of lending and lending basics is critical for effective credit analysis.

  • Source: Sathye M., Bartle J., Boffey R. (2012) Credit Analysis & Lending Management, Tilde University Press.

LEARNING OBJECTIVES

  • Identify the basic principles governing bank lending and explain their importance.

  • Understand the framework for credit and lending decisions.

  • Comprehend the credit process.

  • Explain various types of bank advances and their characteristics.

  • Distinguish different borrowers and their specific considerations.

  • Understand how advances are structured.

  • Recognize the importance of credit culture in lending institutions.

  • Design an advance portfolio.

PRINCIPLES OF GOOD LENDING

  • Safety of Loan: Loans should only be granted to borrowers who are considered safe (good character).

  • Suitability of Loan: Loans must serve a legitimate purpose, aligning with the bank’s lending policy.

  • Profitability: Banks must ensure loans are profitable, weighing costs against benefits.

  • Credit Analysis Compliance: Adhere to traditional or modern credit analysis methods.

TRADITIONAL METHODS OF CREDIT ANALYSIS

  • Focus on measuring credit risk using the 5 Cs:

    1. Character: Borrower's integrity and repayment history.

    2. Capacity: Ability to repay the loan on time with interest.

    3. Capital: Borrower’s investment in the project establishing their stake.

    4. Collateral: Security that can back the loan if default occurs.

    5. Conditions: Economic and industry conditions affecting repayment.

QUESTIONS IN CREDIT ANALYSIS

  1. What is the borrower’s character and information quality?

  2. What will loan proceeds be used for?

  3. How much is the borrower requesting?

  4. What is the primary repayment source and timeframe?

  5. What collateral is available as a secondary repayment source?

ADDITIONAL APPROACHES TO CREDIT ANALYSIS

  • Alongside the 5 Cs, modern approaches include:

    • Rating Systems: Agencies like Moody’s provide risk scores.

    • Credit Scoring System: Quantitative assessment of default probability using key factors.

MODERN APPROACHES TO CREDIT ANALYSIS

  • Common methods include:

    • Econometric Techniques: Modeling default probability.

    • Optimization Models: Minimizing lender errors to maximize profits.

    • Neural Networks: Emulating human decision-making with data.

FRAMEWORK FOR CREDIT AND LENDING PROCESS

Factors in Lending Decisions

  • Internal Factors: Lending policy, budgets, staffing.

  • External Factors: General laws, macroeconomic conditions, industry specifics, regulatory acts.

BORROWER SPECIFIC FACTORS

  • Examine the unique aspects of the borrower’s profile against the 5 Cs to ensure sound lending decisions.

THE CREDIT PROCESS

Key Components

  1. Business Development and Credit

    • Includes market research, loan proposals, and advertising.

  2. Credit Execution and Review

    • Officers evaluate compliance, make decisions, and monitor borrowers.

LOAN POLICY

  • Guidelines facilitating structured lending practices in banks, influencing credit philosophy and culture.

STRUCTURING ADVANCES

Major Aspects of Structuring Advances

  • Obtaining Security: Establishing appropriate documentation for collateral.

  • Debt Covenants: Conditions agreed upon in the loan agreement to protect lender interests.

  • Pricing: Interest rates, fees, and total cost for the borrower.

ADVANCE TYPES

Traditional Types of Advances

  • Loans: Lump-sum giving with terms for repayment (secured vs. unsecured).

  • Overdrafts: Flexible borrowing without fixed repayment terms, often associated with current accounts.

Modern Types of Advances

  • Equity Participation: Banks provide equity to large businesses.

  • Loan Syndication: Multiple lenders share risks to meet large financial needs.

  • Factoring: Purchasing debts at a discount for immediate cash flow.

DIFFERENT TYPES OF BORROWERS

Categories of Borrowers

  1. Minors: Cannot enter binding loan contracts.

  2. Persons of Unsound Mind: Contracts can be avoided by proving incapacity.

  3. Insolvents: Should not receive loans if insolvency proceedings are pending.

BUSINESS BORROWERS

  • Types include:

    • Sole Proprietorships: Owned individually.

    • Partnerships: Shared profits among partners.

    • Companies: Borrowing requires board resolutions.

SPECIAL TYPES OF BORROWERS

  • Local Authorities: Their borrowing power must be examined.

  • Clubs and Schools: Check bylaws as they have no legal entity.

  • Cooperatives: Similar scrutiny as clubs and associations.

PERFECTING THE SECURITY INTEREST

  • The bank must ensure its claim is superior and properly documented.

LOAN COVENANTS

Types of Covenants

  • Positive (Affirmative): Provisions that must be adhered to by the borrower.

  • Negative: Restrictions and conditions for the borrower.

SAMPLE LOAN COVENANTS

Examples of Negative and Affirmative Covenants

  • Limits on capital expenditures, financial ratios, and management changes.

  • Requirements for maintaining property and providing financial statements.

THE VIRTUOUS CYCLE

  • Credit-granting, repayment, and monitoring processes must work in harmony for success.

CREDIT SCORING MODEL

Sample Scoring Approach

  • Assign points based on client details to assess creditworthiness.

SAMPLE CREDIT DECISION

Scoring Outcome

  • Decisions on loans based on point scores; stipulating acceptance conditions based on established thresholds.