Commercial and Industrial Lending

1
Commercial and Industrial Lending

• Outline
• The role of asymmetric information in lending
• The competitive environment
• The Board of Directors written loan policy
• Seven ways to make loans
• Principal lending activities
• Collateral
• The lending process

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The role of asymmetric information in lending

• Asymmetric information and adverse selection
• Inequality of information between the lender and
  borrower. Given imperfect information is
  available to lenders, the average interest rate
  is too high for borrowers with low-risk
  investment projects, and too low for borrowers
  with high-risk investment projects.
• Adverse selection means that high-risk borrowers
  are willing to pay the average rate of interest,
  and low-risk borrowers are not willing to pay it.
  Thus, banks tend to attract higher than average
  borrowers before loans are made.
• Moral hazard occurs after a loan is made. The
  borrower has an incentive to engage in higher
  risk activities (to earn higher returns) at the
  expense of the bank.
• Banks must use effective monitoring to reduce
  adverse selection and moral hazard risks.

3
The competitive environment

• The business of lending
• Profits on interest income and fee income.
• Earn higher profits by taking more risk.
• Credit risk can cause the borrower to default on
  loans causing losses to the bank (i.e., borrower
  has a put option on a loan).
• Increasing competition
• Expectation of high returns attracts competition.
• Banks syndicate loans to compete with investment
  bankers to finance large firms.
• Nonbank lenders have increased their lending
  activities.
• Changes in technology
• Securitization to package and sell otherwise
  unmarketable loans.
• Credit scoring to estimate the probability a
  borrower will default based on statistical/compute
  r models (e.g., Fair Isaac -- see
  www.fairisaac.com).
• J.P. Morgan (1997) introduces CreditMetrics, a
  VAR approach to measuring credit portfolio risk.
  Other firms are developing VAR models.

4
The Board of Directors written loan policy

• The role of Directors
• Provide guidelines and principles for the banks
  lending activities
• Loan authority, loan portfolio, geographic
  limits, pricing policies, off-balance sheet
  exposure limits, and loan review process.
• Reducing credit risk
• Avoid making high-risk loans.
• Use collateral to reduce risk (i.e., secondary
  source of payment).
• Diversify by lending to different types of
  borrowers and avoiding undue concentration to a
  borrower or group of borrowers.
• Documentation needed to legally enforce a loan
  contract.
• Guarantees by third parties can reduce risk
  (e.g., the Small Business Administration assists
  small businesses with guarantees).
• Monitor the behavior of the borrower after the
  loan is made. Agency problems of lender to
  influence the behavior of the borrower.
• Transfer risk to other parties via securitization
  and loan participations.

5
Seven ways to make loans

• Banks solicit loans (sales, cross-selling, etc.).
• Buying loans (participations with other banks --
  when 3 or more unaffiliated banks make a loan in
  excess of 20 million, it is called a shared
  national credit).
• Loan commitments (an agreement between a bank and
  a firm to lend funds in the future based on
  agreed written terms).
• Customers request loans.
• Loan brokers (help arrange loans by approaching
  banks and other lenders with prospective loan
  deals with firms).
• Overdrafts (that occur when a customer writes a
  check on uncollected funds or there are
  insufficient funds).
• Refinancing of loans (due to lower loan rates).

6
Principal lending activities

• Loans and leases for temporary assets versus
  permanent assets
• Line of credit is a predetermined amount
  available to the firm upon request (under
  established terms and conditions). Normally for
  working capital needs or temporary assets for one
  year or less.
• Revolving line of credit is a guaranteed maximum
  amount of loans available to the firm. Normally
  for temporary assets but can be for more than 2
  years.
• Term loan is a single loan for a stated period of
  time, or a series of loans on specified dates.
  Normally for permanent assets (e.g.,, machinery,
  building renovation, refinancing debt, etc.) and
  can be for more than 5 years. Value of loan
  should be less than value of asset, as borrower
  equity is positive (i.e., incentive to pay off
  the loan). Maturity of loan should not exceed
  the life of the asset.
• Bridge loan helps to finance working capital or
  other needs for a short period of time within
  which the firm is seeking alternative financing
  (e.g., a commercial paper issuance).

7
Principal lending activities

• Loans and leases for temporary assets versus
  permanent assets
• Asset-based lending is using the assets of the
  firm to secure a loan. All secured loans can be
  classified as asset-based lending. Unlike
  regular CI loans, greater weight is placed on
  the market value of the collateral. Also,
  greater monitoring of the existence, value, and
  integrity of collateral is performed than for
  other secured loans.
• Leasing is used to finance tangible assets,
  including cars, airliners, and ships. A lease
  contract enables the user -- lessee -- to secure
  the use of the tangible asset for a specified
  period of time by making payments to the owner --
  lessor. Operating leases are short-term
  contracts, whereas financial leases are long-term
  with terms that equal the economic life of the
  asset.

8
Collateral

• Definition An asset pledged against the
  performance of an obligation.
• Does not reduce the risk of the loan per se
  (which is tied to ability of the borrower to
  repay a loan and other factors).
• Reduces bank risk but increases costs of lending
  and monitoring.
• Characteristics of good collateral
• Durability is the ability of the asset to
  withstand wear. Durable versus nondurable
  collateral.
• Identification due to physical uniqueness or
  serial numbers.
• Marketability of the property if resold.
• Stability of value over the period of the loan.
• Standardization by government or industry
  guidelines in grading quality of assets.

9
Collateral

• Types of collateral
• Accounts receivable can be used by means of
• Pledging wherein the firm retains ownership of
  the receivables and no notification to the buyer
  of the goods.
• Factoring wherein the receivables are sold to a
  factor such as a bank or finance company. The
  buyer now pays the factor for the goods. Factors
  usually buy receivables on a nonrecourse basis
  (so they cannot be returned to the seller by the
  bank).
• Bankers acceptance to finance foreign goods in
  transit, which is an account receivable to the
  exporter. A time draft is created which must be
  paid by the importer when goods are finally
  delivered. The time draft becomes a negotiable
  instrument that can be traded in securities
  markets after the importers bank accepts it.
• Inventory
• Marketable securities
• Real property and equipment
• Guarantees by third parties (e.g., a U.S.
  government agency)

10
The lending process

• Evaluating a loan request
• 6 Cs of credit
• Character (personal traits and attitudes about
  commitment to pay debt)
• Capacity (borrowers success at running a
  business -- cash flows)
• Capital (financial condition of the borrower --
  net worth)
• Collateral (pledged assets)
• Conditions (economic conditions)
• Compliance (compliance with laws and regulations,
  such as the Community Reinvestment Act, the
  Environmental Superfund Act, lender liability,
  etc.).
• Structuring commercial loan agreements
• Terms of the loan agreement
• Type of credit facility (e.g., term loan) and
  amount to be borrowed.
• Term of loan/method of repayment/ interest rates
  and fees/collateral
• Covenants (promises by the borrower to take or
  not take certain actions during the term of the
  loan)

11
The lending process

• Pricing commercial loans
• How to calculate the effective yield
• The nominal interest rate is the stated rate in
  the loan agreement. The effective yield takes
  into account the payment accrual basis and the
  payment frequency.
• Payment accrual basis refers to the number of
  days used in the interest rate calculation. For
  example, 365-day year and 360-day year
  calculations (1 million at 10 has a daily
  payment of 273.97 using 365 days versus 277.78
  using 360 days).
• Number of days outstanding can be actual number
  of days or a 30-day month base.
• Frequency of interest payments can be monthly,
  quarterly, or annual.

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The lending process

• Loan pricing
• Markups
• Index rate (i.e., prime rate) plus a markup of
  one or more percentage points.
• Cost of funds (i.e., 90-day CD rate) plus a
  markup.
• These methods are simple but may not properly
  account for loan risk, cost of funds, and
  operating expenses.
• Loan pricing models
• Return on net funds employed
• Marginal cost of capital (funds) Profit goal
  (Loan income - Loan expense)/Net bank funds
  employed
• Here the required rate of return is marginal cost
  of capital (funds) Profit goal. We assume that
  marginal cost of capital equals the weighted
  average cost of capital (WACC) equals 6.
• The profit goal considers the risk of each loan
  to determine the markup. Assume this equals 2.
• Loan expense includes all direct and indirect
  costs of the loan but not the banks interest
  cost of funds. Assume 2,000 for labor, etc.
• Net bank funds employed is the average amount of
  the loan over its life, less funds provided by
  the borrower, net of Fed reserve requirements.
  Assume 100,000.
• (6 2) (Loan income - 2,000)/100,000
• Loan income 10,000. Must earn this amount
  to reach the required rate of return.

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The lending process

• Relationship pricing
• Must consider all investment cash flows in the
  loan pricing decision.
• Minimum spread
• Compare the lending rate to the cost of funds
  plus a profit margin.
• Average cost versus marginal cost
• When market interest rates are changing, average
  cost could clearly be incorrect.
• If a loan was match funded by issuing CDs, the
  marginal cost is clearly more appropriate.
• Performance pricing
• Change the loan rate if the firms riskiness
  changes.
• Monitoring and loan review
• Compliance with loan agreement.