BANK LENDING:

POLICIES AND
PROCEDURES
Paarthasaarathi
Associate Professor
Department of Finance
AICAR BUSINESS SCHOOL, MUMBAI

I. TYPES OF BANK LOANS

Real estate loans: short-term loans for

construction and land development and longerterm loans for the purchase of farmland, homes,
apartments, commercial structures, and foreign
properties.
Financial institution loans: loans to other
banks, insurance companies, finance companies,
and other financial institutions.
Agricultural loans: loans to finance farm and
ranch operations, mainly to assist in planting
and harvesting crops and to support the feeding
and care of livestock.

I. TYPES OF BANK LOANS

4. Commercial and industrial loans: to
businesses to cover expenditures on inventories,
paying taxes, and meeting payrolls.
5. Loans to individuals: credit to finance the
purchase of automobiles, appliances, and other
consumer goods, equity lines for home
improvements, and other personal expenses
6. Bank Leasing to corporate firms on equipment
or vehicles.

I. TYPES OF BANK LOANS

Loans Outstanding for Commercial Ban

ks

II. Determining the Size

and Mix of Bank Loans
The characteristics of the market it serves:
The demand for loans by local customers
Local economic conditions.

Bank regulation and capital requirements

determines its legal lending limit to a
single borrower and the total loan size.

II. Factors Determining the

Growth and Mix of Bank
Loans
The bank's official loan principal
and
policy: The key factor determining the
composition of a banks loan portfolio.
The loan rates policy by a bank: Borrowers
have
been
shopping
around
for
competitive loans.

III. Regulation of Lending

Regulations on lending limits:
Banks cannot grant real estate loans by
more than the total amount of bank's
capital and surplus or 70 percent of its
total time and savings deposits,
whichever is greater.
A loan to a single customer normally
cannot exceed 15 percent of a national
bank's capital and surplus account.

III. Regulation of Lending

Regulation on Borrowers Protection:
The RBI guidelines require that the household
borrower be quoted the "true cost" of a loan,
as reflected in the annual percentage interest
rate (APR) and all required charges and fees
for obtaining credit, before the loan agreement
is signed.

III. Regulation of Lending

Regulation on Bank Rating: The Uniform Financial
Institutions Rating System would rate each bank
by assigning a numerical rating based on the
quality of its asset portfolio:
1 = strong performance.
2 = satisfactory performance.
3 = fair performance.
4 = marginal performance.
5 = unsatisfactory performance.
The higher a bank's asset-quality rating, the less
frequently it will be subject to review and
examination by RBI.

III. Regulation of Lending

The Uniform Financial Institutions Rating System, numerical
ratings are also assigned based on examiner judgment of
the bank's capital adequacy, management quality, earnings
record, liquidity position, and sensitivity to market risk
exposure. The CAMELS rating:
Capital adequacy.
Asset quality.
Management quality.
Earnings record.
Liquidity position.
Sensitivity to market risk
Banks with an overall rating of 4 or 5-are examined more
frequently than the highest-rated banks, those with ratings
of 1,2, or 3.

IV. Establishing a Loan

Policy
Important elements of a good bank loan
policy as suggested by the RBI
1. A clear mission statement for the
bank's 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 (measuring the maximum
amount and types of loan that each
person and committee can approve and
what signatures are required).

IV. Establishing a Loan

Policy
3. Lines 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 documentation that is to
accompany each loan application and
what must be kept in the bank's credit
files (required financial statements,
security agreements, etc.).

IV. Establishing a Loan

Policy
6. Lines of authority within the bank,
detailing who is responsible for maintaining
and reviewing the bank's credit files.
7. Guidelines for taking, evaluating, and
perfecting loan collateral.
8. A presentation of policies and
procedures for setting loan interest rates
and c fees and the terms for repayment of
loans.
9. A statement of quality standards
applicable to all loans.

IV. Establishing a Loan

Policy
10. A statement of the preferred upper
limit for total loans outstanding (i.e., the
maximum ratio of total loans to total
assets allowed).
11. A description of the bank's 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.

V. Steps in the Lending

Process
1. Loan requests:
often arise from contacts the bank's loan
officers and sales representatives make
as they solicit new accounts from
individuals and firms operating in the
bank's market area.
2. Customers fill out a loan application.
3. An interview with a loan officer.
Interview provides an opportunity for the
bank's loan officer to assess the
customer's character and sincerity of
purpose.

V. Steps in the Lending

Process
4. Site visits:
If a business or mortgage loan is applied for, a site
visit is usually made by an officer of the bank.
5. Credit References:
The loan officer may contact other creditors who
have previously loaned money to this customer for
credit references.
6. Financial Statements and Documentation

needed for Loan Evaluation, including:

complete financial statements and,
board of directors' resolutions authorizing the
negotiation of a loan with the bank.

V. Steps in the Lending

Process
7. Credit Analysis:

The credit analysis is aimed determining whether

the customer has sufficient cash flows and
backup assets to repay the loan.
8. Perfecting the Banks Claims to Collateral:
To ensure that the bank has immediate access to
the collateral or can acquire title to the property
involved if the loan agreement is defaulted.
9. Preparing a Loan Agreement:
Once the loan and the proposed collateral are
satisfied, the note and other documents that
make up a loan agreement are prepared and are
signed by all parties to the agreement.

V. Steps in the Lending

Process
10. Loan Monitoring:
The new agreement must be monitored
continuously to ensure that the terms of
the loan are being followed and that all
required payments of principal and/or
interest are being made as promised.
For larger commercial credits, the loan
officer will visit the customer's business
periodically to check on the firm's
progress and to see what other services
the customer may need.

V. Steps in the Lending

Process
Usually a loan officer or other staff member
places information about a new loan customer
in a computer file known as a bank customer
profile. This file shows what bank services the
customer is currently using and contains other
information required by bank management to
monitor a customer's progress and financialservice needs.

VI. Credit Analysis

Three major questions regarding each
application must be satisfactorily answered:

loan

1. Is the borrower creditworthy ? How do you

know?
2. Can the loan agreement be properly structured
and documented so that the bank and its
depositors are adequately protected and the
customer has a high probability of being able to
service the loan without excessive strain?
3. Can the bank perfect its claim against the assets
or earnings of the customer so that, in the event of
default, bank funds can be recovered rapidly at low
cost and with low risk?

VI. Credit Analysis: The

Five Cs
Character:
The loan officer must be convinced that the
customer has a well-defined purpose for
requesting bank credit and a serious intention
to repay.

Capacity:
The loan officer must be sure that the
customer requesting credit has the authority to
request a loan and the legal standing to sign a
binding loan agreement. This customer
characteristic is known as the capacity to
borrow money.

VI. Credit Analysis: The

Five Cs
Cash.
Three sources of income to repay loans:
(a) cash flows generated from sales or
income,
(b) the sale or liquidation of assets, or
(c) funds raised by issuing debt or equity
securities.
What is cash flow?
Cash flow = Net profits(or total revenue less
all expenses) + Non-cash
expenses

VI. Credit Analysis: The

Five Cs
Another definition used by some accountants and
financial analysts is:
Cash flows = Net profits + Non-cash expenses +
Additions to accounts payable Additions to inventories and
accounts receivable.
This latter definition of cash flow is that it helps to
focus a bank loan officer's attention on those
facets of a customer's business that reflect the
quality and experience of its management and
the strength of the market the customer serves.

VI. Credit Analysis: The

Five Cs
Collateral:
Does the borrower possess adequate net worth
or own enough quality assets to provide
adequate support for the loan? The loan officer
is particularly sensitive to such features as the
age, condition, and degree of specialization of
the borrower's assets.

VI. Credit Analysis: The

Five Cs
Conditions:
The loan officer and credit analyst must
be aware of recent trends in the
borrower's line of work or industry and
how changing economic conditions might
affect the loan. To assess industry and
economic conditions, most banks
maintain files of information-newspaper
clippings, magazine articles, and research
reports-on the industries represented by
their major borrowing customers.

VI. Credit Analysis: Beyond

The Five Cs
Control:
Control centers on such questions as whether
changes in law and regulation could adversely
affect the borrower and whether the loan
request meets the bank's and the regulatory
authorities' standards for loan quality.

VII. Structuring and

Documenting Loans
Structuring a Loan:
Drafting a loan agreement that meets the
borrower's need for funds with a comfortable
repayment schedule.
Anticipating and accommodating of a customer
who may request more or less funds than
requested, over a longer or shorter period.

VII. Structuring the Loans

Imposing
certain
restrictions
(covenants) on the borrower's activities
to protect the banks when these
activities could threaten the recovery of
bank funds.
Specifying the process of recovering the
bank's funds - when and where the
bank can take action to get its funds
returned.

VIII. Perfecting the

Banks Claim on
Reasons for Taking Collateral:
Collateral
The pledge of collateral gives the lender the
right to seize and sell those assets designated
as loan collateral, using the proceeds of the
sale to cover what the borrower did not pay
back.
Collateralization of a loan gives the lender a
psychological advantage over the borrower.
Because specific assets may be at stake, a
borrower feels more obligated to work hard to
repay his or her loan and avoid losing valuable
assets.

VIII. Perfecting the

Banks Claim on
The goal of a bank taking collateral:
Collateral
To precisely define which borrower assets are
subject to seizure and sale and to document
for all other creditors to see that the bank has
a legal claim to those assets in the event of
nonperformance on a loan.

VIII. Perfecting the

Banks Claim on
Common Types of Loan Collateral:
Collateral
Accounts Receivable.
The bank takes a security interest in the form of
a stated percentage of the face amount of
accounts receivable (sales on credit) shown on a
business borrower's balance sheet.
When the borrower's credit customers send in
cash to retire their debts, these cash payments
are applied to the balance of the borrower's loan.
Two ways to evaluate accounts receivable:
Accounting receivable aging;
Accounting receivable turnover.

VIII. Perfecting the

Banks Claim on
Collateral

Factoring.
A bank can purchase a borrower's
accounts receivable based upon some
percentage of their book value.
The borrower's customers are required to
send their payments to the purchasing
bank.
Usually the borrower promises to set
aside funds in order to cover some or all
of the losses that the bank may suffer
from any unpaid receivables.

VIII. Perfecting the

Banks Claim on
Inventory.
Collateral
A bank will lend only a percentage of the
estimated market value of a borrower's
inventory:

Floating Lien: The inventory pledged may be controlled

completely by the borrower.
Floor planning: The lender takes temporary ownership
of any goods placed in inventory and the borrower
sends payments or sales contracts to the lender as the
goods are sold.
Ways to evaluate inventory:
Resale of inventory;
Inventory turnover;
Inventory converted to accounts receivable.

VIII. Perfecting the

Banks Claim on
Estate Property:
Collateral

Real
Public notice of a mortgage against real
estate is filed with the Registrar in the
place where the property resides.
The bank may also take out title
insurance and insist that the borrower
purchase insurance to cover damage
from floods and other hazards, with the
bank receiving first claim on any
insurance settlement that is made.

VIII. Perfecting the

Banks Claim on
Approaches to the valuation of real estate:
Collateral
The Cost approach: the reproduction
cost of the
building and improvements, deducts estimated
depreciation, and adds the value of the land.
Market Data or direct sales comparison approach:
estimate the value of the subject property based
on the comparable properties selling prices.
The income approach: the discounted value of
the future net operating income streams.
The direct capitalization (cap rate) approach:
calculate the value by dividing an estimate of its
stabilized annual income by a factor called
cap rate.

VIII. Perfecting the

Banks Claim on
Personal Property:
Collateral
Banks take a security interest in automobiles,
furniture, jewelry, securities, and other forms
of personal property owned by a borrower.
A financing statement will be filed publicly in
those cases where the borrower keeps
possession
of
any
personal
property
hypothecated.
A pledge agreement may be prepared if the
bank or its agent holds the pledged property,
giving the bank the right to control that
property until the loan is repaid in full.

VIII. Perfecting the

Banks Claim on
Personal Guarantees:
Collateral
A pledge of the stock, deposits, or other
personal assets held by the major stockholders
or owners of a company may be required as
collateral to secure a business loan.
Guarantees are often sought by banks in
lending to smaller businesses or to firms that
have fallen on difficult times. This gives the
owners an additional reason to want their firm
to prosper and to repay their loan.

VX. Sources of Information

about Loan Customers
Rating Agencies publishes many ratios and group
them by industry and firm size:
Current assets to current liabilities (the current
ratio).
Current assets minus inventories to current
liabilities (the quick ratio).
Sales to accounts receivable.
Cost of sales to inventory (the inventory
turnover ratio).
Earnings before interest and taxes to total
interest payments (the interest coverage
ratio).

VX. Sources of Information

about Loan Customers
Fixed assets to net worth.
Total debt to net worth (the leverage ratio).
Profits before taxes to total assets and tangible
net worth.
Total sales to net fixed assets and to total assets.
Rating Agencies also calculates common-size
balance sheets (with all major asset and liability
items expressed as a percentage of total assets)
and common-size income statements (with profits
and operating expense items expressed as a
percentage of total sales) for different size groups
of firms within an industry.

VX. Sources of Information

about Loan Customers
Rating Agencys Industry Surveys provides
information for analyzing loan applications
from business borrowers.
They provide a detailed analysis of recent trends in
the borrower's industry and that industry's future
outlook. Analysts working for Standard & Poor's
examine the prospects for each industry's future
sales growth and profitability, the expected impact
of technological changes, trends in industry
organizational structure and competition, what' s
happening to the prices of industry goods and
services, and new product developments within each
major industrial group where banks make loans.

VX. Sources of Information

about Loan Customers
Dun & Bradstreet Credit Services:
This agency collects information on approximately 3
million firms in 800 different business lines. D&B
prepares detailed financial reports on individual
borrowing companies for its subscribers. For each
firm reviewed, the D&B Business Information
Reports provide a credit rating, a brief financial and
management history of the firm, a summary of
recent balance sheet and income and expense
statement trends, a listing of any major loans
known to be still outstanding against the firm, its
terms of trade, the names of its key managers, and
the location and condition of the firm's facilities.

X. Parts of a Typical Loan

Agreement
Collateral. Secured loan agreements
include a section describing any assets
that are pledged as collateral, along with
an explanation of how and when the bank
can take possession of the collateral in
order to recover its funds.
Covenants. Most formal loan agreements
also contain restrictive covenants,
which are usually one of two types:
affirmative or negative.

X. Parts of a Typical Loan

Agreement
1. Affirmative covenants require the borrower to
take certain actions, such as periodically filing
financial statements with the bank, maintaining
insurance coverage on the loan and on any
collateral pledged, and maintaining specified
levels of liquidity and equity.
2. Negative covenants restrict the borrower from
doing certain things without the bank's approval,
such as taking on new debt, acquiring additional
fixed assets, participating in mergers, selling
assets, or paying excessive dividends to
stockholders.

X. Parts of a Typical Loan

Agreement
Borrower Guaranties or Warranties.
In most loan agreements, the borrower
specifically guarantees or warranties that
the information supplied in the loan
application is true and correct. The borrower
may also be required to pledge personal
assets behind a business loan or against a
loan that is cosigned by a third party.
Whether collateral is posted or not, the loan
agreement must identify who or what
institution is responsible for the loan and
obligated to make payment.

X. Parts of a Typical Loan

Agreement
Events of Default.
Finally, most loans
contain a section listing events of default,
specifying what actions or inactions by the
borrower would represent a significant
violation of the terms of the loan agreement
and what actions the bank is legally
authorized to take in order to secure the
recovery of its funds. The events-of-default
section also clarifies who is responsible for
collection costs, court costs, and attorney's
fees that may arise from litigation of the
loan agreement.

XI. Loan Review

1. Reviewing all types of loans on a periodic
basis - every 30, 60, or 90 days on the
largest loans, along with a random sample
of smaller loans.
2. Detailed the loan review process
carefully to include:
a. The record of borrower payments, to
ensure that the customer is not falling
behind the planned repayment schedule.
b. The quality and condition of any
collateral pledged behind the loan.

XI. Loan Review

c. The completeness of loan documentation, to
make sure the bank has access to any collateral
pledged and possesses the full legal authority
to take action against the borrower in the
courts if necessary.
d. An evaluation of whether the borrower's
financial condition and forecasts have changed,
which may have increased or decreased the
borrower's need for bank credit.
e. An assessment of whether the loan conforms
to the bank's lending policies and to the
standards applied to its loan portfolio by
examiners from the regulatory agencies.

XI. Loan Review

3. Reviewing most frequently the largest loans,
because default on these credit agreements could
seriously affect the bank's own financial
condition.
4. Conducting more frequent reviews of troubled
loans, with the frequency of review increasing as
the problems surrounding any particular loan
increase.
5. Accelerating the loan review schedule if the
economy slows down or if the industries in which
the bank has made a substantial portion of its
loans develop significant problems.

XII. Handling Problem Loan

Situations
Common features to problem loans:
1. Unusual or unexplained delays in receiving
promised financial reports and payments or in
communicating with bank personnel.
2. Sudden changes in methods used by the
borrowing firm to account for depreciation, make
pension plan contributions, value inventories,
account for taxes, or recognize income.
3. For business loans, restructuring outstanding
debt or eliminating dividends, or experiencing a
change in the customer's credit rating.

XII. Handling Problem Loan

Situations
4. Adverse changes in the price of a borrowing
customer's stock.
5. Net earnings losses in one or more years,
especially as measured by returns on the
borrower's assets (ROA), or equity capital (ROE),
or earnings before interest and taxes (EBIT).
6. Adverse changes in the borrower's capital
structure (equity/debt ratio), liquidity (current
ratio), or activity levels (e.g., the ratio of sales to
inventory).

XII. Handling Problem Loan

Situations
7. Deviations of actual sales or cash flow
from those projected when the loan was
requested.
8. Sudden, unexpected, and unexplained
changes in deposit balances maintained by
the customer.

XII. Handling Problem Loan

Situations
What should a banker do when a loan is in
trouble?
1. Always keep the goal of loan workouts firmly in
mind: to maximize the bank's chances for the full
recovery of its funds.
2. The rapid detection and reporting of any
problems with a loan are essential; delay often
worsens a problem loan situation.
3. Keep the loan workout responsibility separate
from the lending function to avoid possible
conflicts of interest for the loan officer.

XII. Handling Problem Loan

Situations
4. Bank workout specialists should confer with the
troubled customer quickly on possible options,
especially for cutting expenses, increasing cash
flow, and improving management control.
Precede this meeting with a preliminary
analysis of the problem and its possible causes,
noting any special workout problems.
Develop a preliminary plan of action after
determining the banks risk exposure and the
sufficient of loan documents (especially any
claims against the customers collateral other
than that held by the bank.)

XII. Handling Problem Loan

Situations
5. Estimate what resources are available to
collect the troubled loan (including the estimated
liquidation values of assets and deposits).
6. Loan workout personnel should conduct a tax
and litigation search to see if the borrower has
other unpaid obligations.
7. For business borrowers, bank loan personnel
must evaluate the quality, competence, and
integrity of current management and visit the site
to assess the borrower's property and operations.

XII. Handling Problem Loan

Situations
8. Bank workout professionals must consider all
reasonable alternatives cleaning up the troubled
loan, including making a new, temporary
agreement if loan problems appear to be shortterm in nature or finding a way to help the
customer strengthen cash flow (such as reducing
expenses or entering new markets) or to infuse
new capital into the business. Other possibilities
include finding additional collateral, securing
endorsements or guarantees, reorganizing,
merging or liquidating the firm, or filing a
bankruptcy petition.

Thank you.

Copyright by t.r. paarthasaarathi

All rights reserved. This material may not be reproduced, displayed, modified or distributed without the express prior
written permission of the author

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