Chapter 13
Overview of Credit Policy and Loan Characteristics
Chapter Objectives
1. Describe recent trends in bank loan growth and quality and data for ditierent-size banks.
2. Provide an overview of the credit process at commercial banks.
3. Describe the characteris”cs of ditierent types of loans.
4. Explain what nega”ve and posi”ve (a’rma”ve) loan covenants are.
5. Introduce cash-to-cash cycle comparisons for working capital loans.
Key Concepts
1. Loans are the dominant earning asset at most commercial banks comprising between 50%
and 80% of total assets. Real estate loans are the dominant loans for most banks, but loan
composi”on for individual banks reflect management’s strategies and target markets.
2. Since the early 1990s, loan quality has improved drama”cally as loan charge-otis and
noncurrent loans have decreased sharply. Only credit card loans experienced rising loss
rates, which is par”cularly disturbing given the robust economic condi”ons in the U.S. during
the 1990s. From 2000 – 2004, recent data show an increase in noncurrent and problem loans
across many ditierent types of credits followed by a decrease for real estate and commercial
& industrial loans. The increase appears to be par”cularly strong for loans to individuals. The
number of bankruptcy :lings and credit card charge-oti rates con”nue to rise as well.
3. The credit process involves three func”ons: business development and credit analysis, credit
execu”on and administra”on, and credit review. Credit analysis involves the examina”on of
the risks inherent in making a loan and largely determines whether a bank wants to extend
credit to the prospec”ve borrower.
4. Two types of commercial loans are short-term working capital loans and term loans for the
purchase of depreciable assets and/or facilita”ng mergers and acquisi”ons. Working capital
loans typically require a complete payoti within one year as trading assets are liquidated.
Term loans have maturi”es beyond one year and are repaid from opera”ng cash 1ow.
5. The working capital cycle compares the “ming ditierence between conver”ng current assets
to cash and making cash payments on current liabili”es and opera”ng expenses. The
cash-to-cash cycle is a measure in days of the “me it takes for the underlying firm to convert
assets or liabili”es to cash. The ditierence in the asset cash-to-cash cycle and liability
cash-to-cash cycle provides informa”on about a firm’s poten”al working capital borrowing
requirement. The greater is the asset cash-to-cash cycle, the greater is a firm’s poten”al
borrowing needs.
6. Loans for real estate, agriculture, and other specific purposes generally exhibit features
associated with the assets :nanced or cash 1ow sources of the borrower. Such loans are
priced according to the specific terms of each loan.
7. Consumer loans ditier from commercial loans because they are smaller in size, are oBen
repaid in installments, and generally carry fixed rates. Today, many of the largest ins”tu”ons
credit score most consumer loans and most small business loans. This centralizes the
decision-making, but makes the credit gran”ng process less personal. There is an obvious
trade-oti between otiering the personal service in a “mely fashion and cuCng costs and
mechanizing the credit approval process. Both approaches have been successful.
Teaching Suggestions
Chapter 13 introduces recent trends in loan composi”on at ditierent banks and the quality of
ditierent types of loans. It then describes the characteris”cs of ditierent types of loans, all of
which serve as background material for the detailed credit analysis discussed in later chapters.
Exhibit 13.2 examines credit risk diversi:ca”on across banks that have ditierent loan
concentra”ons. Have students assess where the concentra”ons appear most problema”c at the
end of September 2008. Have students review Exhibits 13.3 through 13.7 and discuss the key
trends. See if they can explain why loan quality has generally changed for all types of loans. Why
have personal bankruptcy :lings and credit card charge-oti rates changed drama”cally since the
early 1990s? Ask students to link the change in asset quality to the income statement. What is
the likely impact on provisions for loan losses and net income, ceteris paribus?
It is also useful to ditieren”ate between short-term loans and term loans. Make sure that
students understand why banks dis”nguish between the two. What are the expected sources of
repayment for each? Emphasize that one way to analyze working capital loan needs is to
es”mate them using the cash-to-cash cycle comparison.
The text introduces many issues that students will be somewhat familiar with including
ditierences between banks, credit unions, pawn shops, car dealers, payday lenders, etc. Have
them otier their perpec”ves on the ditierent strategies regarding loans and ditierent risk-return
profile. Discuss the credit process in detail. Many students want to work for banks and many
new hires begin by analyzing financial informa”on as part of the process.
Have students select a non-financial firm, obtain its most recent annual report, and analyze the
firm’s cash-to-cash working capital cycle. Compare the es”mated “ming ditieren”al with the
firm’s actual short-term bank credit outstanding. Students should recognize the impact of
seasonal trends in a firm’s produc”on process and opera”ons, and thus the importance of
interim financial statements.