Chapter 16 – Lending Policies and Procedures: Managing Credit Risk
16-1
CHAPTER 1
LENDING POLICIES AND PROCEDURES: MANAGING CREDIT RISK
Goal of This Chapter: The purpose of this chapter is to learn why sound lending policies are
important to banks and other lenders and the public they serve and how to spot and deal with
problem loans when they appear in an institution’s portfolio.
Key Topics in This Chapter
• Types of Loans Banks Make
• Factors Affecting the Mix of Loans Made
• Regulation of Lending
• Creating a Written Loan Policy
• Steps in the Lending Process
• Loan Review and Loan Workouts
Chapter Outline
I. Introduction
II. Types of Loans
A. Types of Loans:
1. Real Estate Loans
2. Financial Institutions Loans
3. Agricultural Loans
4. Commercial and Industrial Loans
5. Loans to Individuals
6. Miscellaneous Loans
7. Lease Financing Receivables
B. Factors Determining the Growth and Mix of Loans
1. Characteristics of the Market Area
2. Loan Participations
3. Lender Size
4. Experience and Expertise of Management
5. Institution’s Loan Policy
6. Expected Yield
7. Functional Cost Analysis
Chapter 16 – Lending Policies and Procedures: Managing Credit Risk
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III. Regulation of Lending
A. Relevant Regulations:
1. The Lending Limit
2. Limitation on Real Estate Lending
3. The Community Reinvestment Act (1977)
4. Equal Credit Opportunity Act (1974)
5. Truth-in-Lending Act
6. International Lending Rules
7. Examiner Loan Ratings
8. CAMELS Rating
B. Establishing A Written Loan Policy
IV. Steps in the Lending Process
1. Finding Prospective Loan Customers
2. Evaluating a Prospective Customer’s Character and Sincerity of Purpose
3. Making Site Visits and Evaluating a Prospective Customer’s Credit Record
4. Evaluating a Prospective Customer’s Financial Condition
5. Assessing Possible Loan Collateral and Signing the Loan Agreement
6. Monitoring Compliance with the Loan Agreement and Other Customer
Service Needs
V. Credit Analysis: What Makes a Good Loan?
A. Is the Borrower Creditworthy? The Cs of Credit
1. Character
2. Capacity
3. Cash
4. Collateral
5. Conditions
6. Control
B. Can the Loan Agreement Be Properly Structured and Documented?
C. Can the Lender Perfect Its Claim Against the Borrower’s Earnings and Any Assets
That May Be Pledged as Collateral?
1. Reasons for Taking Collateral
2. Common Types of Loan Collateral
a. Accounts Receivable
b. Factoring
c. Inventory
d. Real Property
e. Personal Property
f. Personal Guarantees
3. Other Safety Devices to Protect a Loan
VI. Sources of Information About Loan Customers
A. Credit Bureaus
B. Publications of Financial Information
C. Information on Economic Conditions
Chapter 16 – Lending Policies and Procedures: Managing Credit Risk
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VII. Parts of A Typical Loan Agreement
A. The Promissory Note
B. Loan Commitment Agreement
C. Collateral
D. Covenants (Affirmative and Negative)
E. Borrower Guaranties or Warranties
F. Events of Default
VIII. Loan Review
A. The Purpose of Loan Review
B. Elements of a Good Loan Review
IX. Loan Workouts
A. Signs of a Developing Problem Loan Situation
B. Steps in Maximizing the Recovery of Funds from a Problem Loan (the Loan Workout
Problem)
X. Summary of the Chapter
Concept Checks
16-1. In what ways does the lending function affect the economy of its community or region?
Bank credit is one of the most important sources of capital that fuels local economic growth and
development. When banks make loans to support the development of new businesses and to aid
the growth of existing businesses, new jobs are created and there is a greater flow of income and
spending throughout the local economy.
16-2. What are the principal types of loans made by banks?
Bank loans are usually classified by the purpose of the loans. The most common classifications
are real estate loans, commercial and industrial loans, loans to financial institutions, credit-card
and other loans to individuals, lease financing, and agricultural production loans. Bank loans
may also be classified by maturity – over one year and one year or less.
16-3. What factors appear to influence the growth and mix of loans held by a lending
institution?
The particular mix of any lending institution’s loan portfolio is shaped by the characteristics of its
market area, the expected yield and cost associated with each type of loan, loan participations,
bank size, the experience and expertise of management, and the institution’s written loan policy
and regulations.
Chapter 16 – Lending Policies and Procedures: Managing Credit Risk
16-4 A lender’s cost accounting system reveals that its losses on real estate loans average 0.45
percent of loan volume and its operating expenses from making these loans average 1.85 percent
of loan volume. If the gross yield on real estate loans is currently 8.80 percent, what is this
lender’s net yield on these loans?
The bank’s net yield on real estate loans must be:
Net Yield on Real Estate Loans = 8.80% – 0.45% – 1.85% = 6.50%
16-5. Why is lending so closely regulated by state and federal authorities?
Lending is closely regulated because it is the center of risk for most lending institutions.
Lending institutions in the U.S. are limited in the loans they can make to a single borrower by the
size of their capital and surplus. They also must limit their real estate loans based on the size of
their total time and savings deposits or capital. Discrimination against borrowers on the basis of
their age, sex, religion, or national origin is prohibited by U.S. law. They also cannot
discriminate against borrowers from certain neighborhoods in their service areas. Any loans
made are subject to examination and review and many are restricted or even prohibited by law.
16-6. What is the CAMELS rating and how is it used?
The CAMELS rating is a system used by federal bank examiners for evaluating the overall
condition of a bank based upon the adequacy of its capital, the quality of its asset portfolio, its
