Download Characteristics of Different Types of Loans Commercial Loans

Funding the Bank
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1
The Relationship Between Liquidity
Requirements, Cash, and Funding Sources
 The amount of cash that a bank holds
is influenced by the bank’s liquidity
requirements
 The size and volatility of cash
requirements affect the liquidity
position of the bank
 Deposits,
withdrawals, loan
disbursements, and loan payments
affect the bank’s cash balance and
liquidity position
2
3
The Relationship Between Liquidity
Requirements, Cash, and Funding Sources
 Recent Trends in Bank Funding Sources
Bank customers have become more rate
conscious
 Many customers have demonstrated a a
strong preference for shorter-term
deposits
 Core deposits are viewed as increasingly
valuable
 Bank often issue hybrid CDs to appeal to
rate sensitive depositors

4
The Relationship Between Liquidity
Requirements, Cash, and Funding Sources
 Recent Trends in Bank Funding
Sources
 Retail

Funding
Deposit Accounts
 Transaction accounts
 Money market deposit accounts
 Savings accounts
 Small time deposits
5
The Relationship Between Liquidity
Requirements, Cash, and Funding Sources
 Recent Trends in Bank Funding
Sources
 Borrowed
Funding
Federal Funds purchased
 Repurchase agreements
 Federal Home Loan Bank borrowings

6
The Relationship Between Liquidity
Requirements, Cash, and Funding Sources
 Recent Trends in Bank Funding
Sources
 Wholesale

Funding
Includes borrowed funds plus large
CDs
 Equity
Funding
Common stock
 Preferred stock
 Retained earnings

7
The Relationship Between Liquidity
Requirements, Cash, and Funding Sources
 Recent Trends in Bank Funding Sources

Volatile (Managed) Liabilities

Funds purchased from rate-sensitive
investors






Federal Funds purchased
Repurchase agreements
Jumbo CDs
Eurodollar time deposits
Foreign Deposits
Investors will move their funds if other
institutions are paying higher rates
8
The Relationship Between Liquidity
Requirements, Cash, and Funding Sources
 Recent Trends in Bank Funding
Sources
 Core
Deposits
Stable deposits that customers are less
likely to withdraw when interest rates
on competing investments rise
 Includes:

 Transactions accounts
 MMDAs
 Savings accounts
 Small CDs
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Characteristics of Retail-Type
Deposits
 Retail Deposits
 Small
denomination (under $100,000,
now $250,000) liabilities
 Normally held by individual investors
 Not actively traded in the secondary
market
13
Characteristics of Retail-Type
Deposits
 Transaction Accounts
 Most
banks offer three different
transaction accounts

Demand Deposits
 DDAs

Negotiable Order of Withdrawal
 NOWs

Automatic Transfers from Savings
 ATS
14
Characteristics of Retail-Type
Deposits
 Transaction Accounts
 Demand
Deposits
Checking accounts that do not pay
interest
 Held by individuals, business, and
governmental units

 Most are held by businesses since
Regulation Q prohibits banks from paying
explicit interest on for-profit corporate
checking accounts
15
Characteristics of Retail-Type
Deposits
 Transaction Accounts
 NOW Accounts
 Checking accounts that pay interest
 ATS Accounts
 Customer has both a DDA and savings
account
 The bank transfers enough from savings
to DDA each day to force a zero balance in
the DDA account
 For-profit corporations are prohibited
from owning NOW and ATS accounts
16
Characteristics of Retail-Type
Deposits
 Transaction Accounts
 Although
the interest cost of
transaction accounts is very low, the
non-interest costs can be quite high

Generally, low balance checking
accounts are not profitable for banks
due to the high cost of processing
checks
17
Characteristics of Retail-Type
Deposits
 Nontransactional Accounts
 Non-transaction
accounts are interestbearing with limited or no checkwriting privileges
18
Characteristics of Retail-Type
Deposits
 Nontransactional Accounts
 Money
Market Deposit Accounts
Pay interest but holders are limited to 6
transactions per month, of which only
three can be checks
 Attractive to banks because they are
not required to hold reserves against
MMDAs

19
Characteristics of Retail-Type
Deposits
 Nontransactional Accounts
 Savings

Have no fixed maturity
 Small

Accounts
Time Deposits (Retail CDs)
Have a specified maturity ranging from
7 days on up
 Large
Time Deposits (Jumbo CDs)
Negotiable CDs of $100,000 or more
 Typically can be traded in the
secondary market

20
Characteristics of Retail-Type
Deposits
 Estimating the Cost of Deposit
Accounts
 Interest
Costs
 Legal Reserve Requirements
 Check Processing Costs
 Account Charges
NSF fees
 Monthly fees
 Per check fees

21
Characteristics of Retail-Type
Deposits
 Estimating the Cost of Deposit
Accounts
 Transaction

Account Cost Analysis
Classifies check-processing as:
 Deposits
 Electronic
 Non-Electronic
 Withdrawals
 Electronic
 Non-Electronic
22
Characteristics of Retail-Type
Deposits
 Estimating the Cost of Deposit Accounts

Transaction Account Cost Analysis

Classifies check-processing as:
 Transit Checks
 Deposited
 Cashed
 Account Opened or Closed
 On-Us checks cashed
 General account maintenance
 Truncated
 Non-Truncated
23
Characteristics of Retail-Type
Deposits
 Estimating the Cost of Deposit
Accounts
 Transaction

Account Cost Analysis
Electronic Transactions
 Conducted through automatic deposits,
Internet, and telephone bill payment

Non-Electronic Transactions
 Conducted in person or by mail

Transit Checks
 Checks drawn on any bank other than the
bank it was deposited into
24
Characteristics of Retail-Type
Deposits
 Estimating the Cost of Deposit Accounts

Transaction Account Cost Analysis

On-Us Checks Cashed
 Checks drawn on the bank’s own customer’s
accounts

Deposits
 Checks or currency directly deposited in the
customer's account

Account Maintenance
 General record maintenance and preparing &
mailing a periodic statement
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Characteristics of Retail-Type
Deposits
 Estimating the Cost of Deposit Accounts
 Transaction Account Cost Analysis
 Truncated Account
 A checking account in which the physical
check is ‘truncated’ at the bank and the checks
are not returned to the customer

Official Check Issued
 A check for certified funds.

Net Indirect Costs
 Those costs not directly related to the product
such as management salaries or general
overhead costs
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Characteristics of Retail-Type
Deposits
 Calculating the Average Net Cost of
Deposit Accounts
 Average

Measure of average unit borrowing
costs for existing funds
 Average

Historical Cost of Funds
Interest Cost
Calculated by dividing total interest
expense by the average dollar amount
of liabilities outstanding
28
Characteristics of Retail-Type
Deposits
 Calculating the Average Net Cost of
Deposit Accounts
Average net cost of bank liabilitie s 
Interest expense  Noninteres t expense - Noninteres t income
12
Average balance net of float  (1 - Reserve requiremen t ratio)
29
Characteristics of Retail-Type
Deposits
 Calculating the Average Net Cost of
Deposit Accounts
 Example:

If a demand deposit account does not
pay interest, has $20.69 in transaction
costs charges, $7.75 in fees, an
average balance of $5,515, and 5%
float, what is the net cost of the
deposit?
Average Net Cost of Demand Deposit 
$0  $20.69 - $7.75
 12  3.29%
$5,515  (1 - .05)  (1 - .10)
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Characteristics of Large
Wholesale Deposits
 Wholesale Liabilities
 Customers
move these investments on
the basis of small rate differentials, so
these funds are labeled:
Hot Money
 Volatile Liabilities
 Short-Term Non-Core funding

32
Characteristics of Large
Wholesale Deposits
 Wholesale Liabilities
 Jumbo CDs
 $100,000 (now $250,000) or more
 Negotiable
 Can be traded on the secondary market
Minimum maturity of 7 days
 Interest rates quoted on a 360-day year
basis
 Insured up to $100,000 (now $250,000) per
investor per institution
 Issued directly or indirectly through a
dealer or broker (Brokered Deposits)

33
Characteristics of Large
Wholesale Deposits
 Wholesale Liabilities
 Jumbo
CDs
Fixed-Rate
 Variable-Rate

 Jump Rate (Bump-up) CD
 Depositor has a one-time option until
maturity to change the rate to the
prevailing market rate
34
Characteristics of Large
Wholesale Deposits
 Wholesale Liabilities
 Jumbo CDs
 Callable
 Zero Coupon
 Stock Market Indexed
 Rate tied to stock market index performance

Rate Boards
 Represent venues for selling non-brokered
CDs via the Internet to institutional investors
 Rate boards help raise funds quickly and
represent a virtual branch for a bank
35
Characteristics of Large
Wholesale Deposits
 Individual Retirement Accounts
 Each
year, a wage earner can make a
tax-deferred investment up to $8,000 of
earned income
 Funds withdrawn before age 59 ½ are
subject to a 10% IRS penalty

This makes IRAs an attractive source of
long-term funding for banks
36
Characteristics of Large
Wholesale Deposits
 Foreign Office Deposits
 Eurocurrency
 Financial claim denominated in a currency
other than that of the country where the
issuing bank is located
 Eurodollar
 Dollar-denominated financial claim at a
bank outside the U.S.
 Eurodollar deposits
 Dollar-denominated deposits in banks
outside the U.S.
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Characteristics of Large
Wholesale Deposits
 Borrowing Immediately Available Funds

Federal Funds Purchased

The term Fed Funds is often used to refer to
excess reserve balances traded between
banks
 This is grossly inaccurate, given reserves
averaging as a method of computing reserves,
different non-bank players in the market, and the
motivation behind many trades


Most transactions are overnight loans,
although maturities are negotiated and can
extend up to several weeks
Interest rates are negotiated between trading
partners and are quoted on a 360-day basis
39
Characteristics of Large
Wholesale Deposits
 Borrowing Immediately Available Funds
 Security Repurchase Agreements (RPs or
Repos)
 Short-term loans secured by government
securities that are settled in immediately
available funds
 Identical to Fed Funds except they are
collateralized
 Technically, the RPs entail the sale of
securities with a simultaneous agreement
to buy them back later at a fixed price plus
accrued interest
40
Characteristics of Large
Wholesale Deposits
 Borrowing Immediately Available Funds

Security Repurchase Agreements (RPs or
Repos)
Most transactions are overnight
 In most cases, the market value of the
collateral is set above the loan amount
when the contract is negotiated.

 This difference is labeled the margin

The lender’s transaction is referred to as a
Reverse Repo
41
Characteristics of Large
Wholesale Deposits
 Borrowing Immediately Available Funds

Structured Repurchase Agreements
Embeds an option (call, put, swap, cap,
floor, etc.) in the instrument to either lower
its initial cost to the borrower or better
help the borrower match the risk and
return profile of an investment
 Flipper Repo

 Carries a floating rate that will convert, or flip,
to a fixed rate after some lock-out period
42
Characteristics of Large
Wholesale Deposits
 Borrowing From the Federal Reserve
 Discount Window
 Discount Rate
 Policy is to set discount rate 1% (1.5%)
over the Fed Funds target for primary
(secondary) credit loans
 To borrow from the Federal Reserve,
banks must apply and provide acceptable
collateral before the loan is granted
 Eligible collateral includes U.S. government
securities, bankers acceptances, and
qualifying short-term commercial or
government paper
43
Characteristics of Large
Wholesale Deposits
 Borrowing From the Federal Reserve
 Discount
Rate
Current Interest Rates in effect since 2/19/2010
Primary Credit
0.75%
Secondary Credit
1.25%
Seasonal Credit
0.20%
Fed Funds Target
0 - 0.25%
44
Characteristics of Large
Wholesale Deposits
 Borrowing From the Federal Reserve
 Primary

Credit
Available to sound depository
institutions on a short-term basis to
meet short-term funding needs
45
Characteristics of Large
Wholesale Deposits
 Borrowing From the Federal Reserve
 Secondary
Credit
Available to depository institutions that
are not eligible for primary credit
 Available to meet backup liquidity
needs when its use is consistent with a
timely return to a reliance on market
sources of funding or the orderly
resolution of a troubled institution

46
Characteristics of Large
Wholesale Deposits
 Borrowing From the Federal Reserve
 Seasonal

Credit
Designed to assist small depository
institutions in managing significant
seasonal swings in their loans and
deposits
47
Characteristics of Large
Wholesale Deposits
 Borrowing From the Federal Reserve
 Emergency

Credit
May be authorized in unusual and
exigent circumstances by the Board of
Governors to individuals, partnerships,
and corporations that are not
depository institutions
48
Characteristics of Large
Wholesale Deposits
 Other Borrowing from the Federal
Reserve
 Term
Auction Facility
Allows banks to bid for an advance that
will generally have a 28-day maturity
 Banks must post collateral against the
borrowings and cannot prepay the loan

49
Characteristics of Large
Wholesale Deposits
 Other Borrowing from the Federal
Reserve
 Term

Securities Lending Facility
A facility in which the Open Market
Trading Desk of the Federal Reserve
Bank of New York makes loans to
primary securities dealers
50
Characteristics of Large
Wholesale Deposits
 Federal Home Loan Bank Advances





The FHLB system is a governmentsponsored enterprise created to assist in
home buying
The FHLB system is one of the largest U.S.
financial institutions, rated AAA because of
the government sponsorship
Any bank can become a member of the FHLB
system by buying FHLB stock
If it has the available collateral, primarily real
estate related loans, it can borrow from the
FHLB
FHLB advances have maturities from 1 day
to as long as 20 years
51
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Electronic Money
 Intelligent Card
 Contains
a microchip with the ability to
store and secure information
 Memory Card
 Simply
store information
53
Electronic Money
 Debit Card
 Online
PIN based
 Transaction goes through the ATM
system

 Offline
Signature based transactions
 Transaction goes through the credit
card system

54
Electronic Money
 Electronic Funds Transfer (EFT)
 An electronic movement of financial data,
designed to eliminate the paper
instruments normally associated with
such funds movement
 Types of EFT







ACH: Automated Clearing House
POS: Point of Sale
ATM
Direct Deposit
Telephone Bill Paying
Automated Merchant Authorization Systems
Preauthorized Payments
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Check 21
 Check Clearing for the 21st Century Act
Facilitates check truncation by reducing
some of the legal impediments
 Foster innovation in the payments and
check collection system without
mandating receipt of check in electronic
form
 Improve the overall efficiency of the
nation’s payment system

57
Check 21
 Check Truncation
 Conversion
of a paper check into an
electronic debit or image of the check
by a third party in the payment system
other than the paying bank
 Facilitates check truncation by
creating a new negotiable instrument
called a substitute check
58
Check 21
 Substitute Check
 The legal equivalent of the original check
and includes all the information contained
on the original
 Check 21 does NOT require banks to
accept checks in electronic form nor
does it require banks to create substitute
checks

It does allow banks to handle checks
electronically instead of physically
moving paper checks
59
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Check 21
 Check Clearing Process
 Banks typically place a hold on a check
until it verifies that the check is “good”
 Expedited Funds Availability Act
 Under Reg CC, it states that:
 Local check must clear in no more than two
business days
 Non-local checks must clear in no more than
five business days
 Government, certified, and cashiers checks
must be available by 9 a.m. the next business
day
61
62
Measuring the Cost of Funds
 Average Historical Cost of Funds
 Many banks incorrectly use the
average historical costs in their pricing
decisions
 The primary problem with historical
costs is that they provide no
information as to whether future
interest costs will rise or fall.
 Pricing decisions should be based on
marginal costs compared with marginal
revenues
63
Measuring the Cost of Funds
 The Marginal Cost of Funds
 Marginal

Measure of the borrowing cost paid to
acquire one additional unit of
investable funds
 Marginal

Cost of Equity
Measure of the minimum acceptable
rate of return required by shareholders
 Marginal

Cost of Debt
Cost of Funds
The marginal costs of debt and equity
64
Measuring the Cost of Funds
 The Marginal Cost of Funds
 Costs
of Independent Sources of
Funds
It is difficult to measure marginal costs
precisely
 Management must include both the
interest and noninterest costs it
expects to pay and identify which
portion of the acquired funds can be
invested in earning assets

65
Measuring the Cost of Funds
 The Marginal Cost of Funds
 Costs
of Independent Sources of
Funds

Marginal costs may be defined as :
Marginal Cost of Liability j

Interest Rate  Servicing Costs  Acquistion Costs  Insurance
Net Investable Balance of Liability j
66
Measuring the Cost of Funds
 The Marginal Cost of Funds
 Costs of Independent Sources of
Funds
 Example:
 Market interest rate is 2.5%
 Servicing costs are 4.1% of balances
 Acquisition costs are 1.0% of balances
 Deposit insurance costs are 0.25% of
balances
 Net investable balance is 85% of the
balance
(10% required reserves and 5% float)
67
Measuring the Cost of Funds
 The Marginal Cost of Funds
 Costs
of Independent Sources of
Funds

Example:
0.025  0.041  0.01  0.0025
Marginal Cost 
 0.0924  9.24%
0.85
68
Measuring the Cost of Funds
 The Marginal Cost of Funds
 Costs
of Independent Sources of
Funds

Cost of Debt
 Equals the effective cost of borrowing from
each source, including interest expense
and transactions costs
 This cost is the discount rate, which
equates the present value of expected
interest and principal payments with the
net proceeds to the bank from the issue
69
Measuring the Cost of Funds
 The Marginal Cost of Funds
 Costs of Independent Sources of Funds
 Cost of Debt
 Example:
 Assume the bank will issue:
 $10 million in par value subordinated
notes paying $700,000 in annual interest
and a 7-year maturity
 It must pay $100,000 in flotation costs
to an underwriter
 The effective cost of borrowing (kd) is
7.19%
70
Measuring the Cost of Funds
 The Marginal Cost of Funds
 Costs
of Independent Sources of
Funds

Cost of Debt
 Example:
7
$700,000 $10,000,000
$9,900,000  

t
7
(1

k
)
(1

k
)
t 1
d
d
Thus k d  7.19%
71
Measuring the Cost of Funds
 The Marginal Cost of Funds
 Costs
of Independent Sources of
Funds

Cost of Equity
 The marginal cost of equity equals the
required return to shareholders
 It is not directly measurable because
dividend payments are not mandatory
72
Measuring the Cost of Funds
 The Marginal Cost of Funds
 Costs
of Independent Sources of
Funds

Cost of Equity
 Several methods are commonly used to
approximate this required return:
 Dividend Valuation Model
 Capital Asset Pricing Model (CAPM)
 Targeted Return on Equity Model
 Cost of Debt + Risk Premium
73
Measuring the Cost of Funds
 The Marginal Cost of Funds
 Costs of Independent Sources of Funds
 Cost of Preferred Stock
 Preferred stock acts as a hybrid of debt and
common equity
 Claims are superior to those of common
stockholders but subordinated to those of
debt holders
 Preferred stock pays dividends that may be
deferred when management determines
that earnings are too low.
 The marginal cost of preferred stock can be
approximated in the same manner as the
Dividend Valuation Model however,
dividend growth is zero
74
Measuring the Cost of Funds
 The Marginal Cost of Funds
 Costs
of Independent Sources of
Funds

Trust Preferred Stock
 Trust preferred stock is attractive because
it effectively pays dividends that are tax
deductible
 This loan interest is tax deductible such
that the bank effectively gets to deduct
dividend payments as the preferred
stock
75
Measuring the Cost of Funds
 Weighted Marginal Cost of Total Funds
 This
is the best cost measure for
asset-pricing purposes
 It recognizes both explicit and implicit
costs associated with any single
source of funds
76
Measuring the Cost of Funds
 Weighted Marginal Cost of Total Funds
 It
assumes that all assets are financed
from a pool of funds and that specific
sources of funds are not tied directly
to specific uses of funds
m
WMC   w j k j
j1
77
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Funding Sources and Banking
Risks
 Banks face two fundamental problems
in managing liabilities. Uncertainty
over:
 What
rates they must pay to retain and
attract funds
 The likelihood that customers will
withdraw their money regardless of
rates
79
Funding Sources and Banking
Risks
 Funding Sources: Liquidity Risk
 The
liquidity risk associated with a
bank’s deposit base is a function of:
The competitive environment
 Number of depositors
 Average size of accounts
 Location of the depositor
 Specific maturity and rate
characteristics of each account

80
Funding Sources and Banking
Risks
 Funding Sources: Liquidity Risk
 Interest Elasticity
 How much can market interest rates
change before the bank experiences
deposit outflows?
 If a bank raises its rates, how many new
funds will it attract?
 Depositors often compare rates and move
their funds between investment vehicles
to earn the highest yields
 It is important to note the liquidity
advantage that stable core deposits
provide a bank
81
Funding Sources and Banking
Risks
 Funding Sources: Interest Rate Risk
Many depositors and investors prefer
short-term instruments that can be rolled
over quickly as interest rates change
 Banks must offer a substantial premium
to induce depositors to lengthen
maturities
 Those banks that choose not to pay this
premium will typically have a negative
one-year GAP

82
Funding Sources and Banking
Risks
 Funding Sources: Interest Rate Risk
 One
strategy is to aggressively
compete for retail core deposits

Individual are not as rate sensitive as
corporate depositors and will often
maintain their balances through rate
cycles as long as the bank provides
good service
83
Funding Sources and Banking
Risks
 Funding Sources: Credit and Capital Risk

Changes in the composition and cost of bank
funds can indirectly affect a bank’s credit
risk by forcing it to reduce asset quality



For example, banks that substitute purchased
funds for lost demand deposits will often see
their cost of funds rise
Rather than let their interest margins
deteriorate, many banks make riskier loans at
higher promised yields
While they might maintain their margins in the
near-term, later loan losses typically rise with
the decline in asset quality
84
13
Overview of Credit
Policy and Loan
Characteristics
85
Recent Trends in Loan Growth
and Quality
 Larger banks have, on average, recently
reduced their dependence on loans
relative to smaller banks.
 Real estate loans represent the largest
single loan category for banks.
 Residential 1-4 family homes contribute
the largest amount of real estate loans
for banks.

Commercial real estate is highest for
banks with $100 million to $1 billion in
assets
86
Recent Trends in Loan Growth
and Quality
 Commercial and industrial loans
represent the second highest
concentration of loans at banks
 Loans to individuals are greatest for
banks with more than $1 billion in
assets
 Farmland and farm loans make up a
significant portion of the smallest
banks’ loans
87
88
Recent Trends in Loan Growth
and Quality
 Wholesale Bank
 Emphasizes
lending to businesses
 Retail Bank
 Emphasizes
lending to individuals
 Primary funding is from core deposits
89
Recent Trends in Loan Growth
and Quality
 FDIC Bank Categories
 Credit
Card Banks
 International Banks
 Agricultural Banks
 Commercial Lenders

Vast majority of FDIC-insured
institutions fall in this category
90
Recent Trends in Loan Growth
and Quality
 FDIC Bank Categories
 Mortgage
Lenders
 Consumer Lenders
 Other Specialized Banks (less than $1
billion)
 All Other Banks (less than $1 billion)
 All Other Banks (more than $1 billion)
91
92
93
94
Recent Trends in Loan Growth
and Quality
 Noncurrent Loans
 Loans and leases past due 90 days or
more and still accruing interest plus all
loans and leases in a nonaccrual status
 Nonaccrual loans and leases are those:
 that are maintained on a cash basis because of
deterioration in the financial position of the
borrower
 where full payment of interest and principal is
not expected
 where principal or interest has been in default
for a period of 90 days or more, unless the
obligation is both well secured and in the
process of collection
95
Recent Trends in Loan Growth
and Quality
 Net Losses (Net Charge-offs)
 The
dollar amount of loans that are
formally charged off as uncollectible
minus the dollar value of recoveries on
loans previously charged off
96
97
98
99
Measuring Aggregate Asset
Quality
 It is extremely difficult to assess individual
asset quality using aggregate quality data
 Different types of assets and off-balance
sheet activities have different default
probabilities
 Loans typically exhibit the greatest credit
risk
 Historical charge-offs and past-due loans
might understate (or overstate) future losses
depending on the future economic and
operational conditions of the borrower
100
Measuring Aggregate Asset
Quality
 Concentration Risk
 Exists
when banks lend in a narrow
geographic area or concentrate their
loans in a certain industry
 Country Risk
 Refers
to the potential loss of interest
and principal on international loans
due to borrowers in a country refusing
to make timely payments
101
Trends in Competition for Loan
Business
 In 1984, there were nearly 14,500 banks
in the U.S.

This fell to fewer than 7,300 at the
beginning of 2007

Recently, the Treasury’s efforts to provide
capital to banks via TARP further
differentiated between strong and weaker
banks, as those in the worst condition did
not qualify for the capital and ultimately
either failed or were forced to sell
 This has forced consolidation
102
Trends in Competition for Loan
Business
 Banks still have the required expertise
and experience to make them the
preferred lender for many types of
loans
 Technology advances have meant that
more loans are becoming
“standardized,” making it easier for
market participants to offer loans in
direct competition to banks
103
Trends in Competition for Loan
Business
 Structured Note
 Loan
that is specifically designed to
meet the needs of one or a few
companies but has been packaged for
resale
104
The Credit Process
 Loan Policy
 Formalizes lending guidelines that
employees follow to conduct bank
business
 Credit Philosophy
 Management’s philosophy that
determines how much risk the bank will
take and in what form
 Credit Culture
 The fundamental principles that drive
lending activity and how management
analyzes risk
105
The Credit Process
106
The Credit Process
 Credit Culture
 The fundamental principles that drive
lending activity and how management
analyzes risk
 Values Driven
 Focus is on credit quality

Current-Profit Driven
 Focus is on short-term earnings

Market-Share Driven
 Focus is on having the highest market
share
107
108
The Credit Process
 Business Development and Credit
Analysis
Business Development
 Market research
 Train employees:

What products are available
 What products customers are likely to
need
 How they should communicate with
customers about those needs

Advertising and Public Relations
 Officer Call Programs

109
The Credit Process
 Business Development and Credit
Analysis

Credit Analysis
Evaluate a borrower’s ability and
willingness to repay
 Questions to address

 What risks are inherent in the operations of the
business?
 What have managers done or failed to do in
mitigating those risks?
 How can a lender structure and control its own
risks in supplying funds?
110
The Credit Process
 Business Development and Credit
Analysis
 Credit

Analysis
Five C’s of Good Credit
 Character
 Capital
 Capacity
 Conditions
 Collateral
111
The Credit Process
 Business Development and Credit
Analysis
 Credit

Analysis
Five C’s of Bad Credit
 Complacency
 Carelessness
 Communication
 Contingencies
 Competition
112
The Credit Process
 Business Development and Credit
Analysis

Credit Analysis

Procedure
1. Collect information for the credit file
2. Evaluate management, the company, and the
industry in which it operates
3. Conduct a financial statement analysis
4. Project the borrower’s cash flow and its
ability to service the debt
5. Evaluate collateral or the secondary source
of repayment
6. Write a summary analysis and making a
recommendation
113
The Credit Process
 Credit Execution and Administration
 Loan
Decision
Individual officer decision
 Committee
 Centralized underwriting

114
The Credit Process
 Credit Execution and Administration
 Loan
Agreement
Formalizes the purpose of the loan
 Terms of the loan
 Repayment schedule
 Collateral required
 Any loan covenants
 States what conditions bring about a
default

115
The Credit Process
 Credit Execution and Administration
 Documentation:
Perfecting the
Security Interest

Perfected
 When the bank's claim is superior to that
of other creditors and the borrower
 Require the borrower to sign a security
agreement that assigns the qualifying
collateral to the bank
 Bank obtains title to equipment or
vehicles
116
The Credit Process
 Credit Execution and Administration
 Position

Maximum allowable credit exposures to
any single borrower, industry, or
geographic local
 Risk

Limits
Rating Loans
Evaluating characteristics of the
borrower and loan to assess the
likelihood of default and the amount of
loss in the event of default
117
The Credit Process
 Credit Execution and Administration
 Loan

Covenants
Positive (Affirmative)
 Indicate specific provisions to which the
borrower must adhere

Negative
 Indicate financial limitations and prohibited
events
118
119
The Credit Process
 Credit Execution and Administration
 Loan Review
 Monitoring the performance of existing
loans
 Handling problem loans
 Loan review should be kept separate from
credit analysis, execution, and
administration
 The loan review committee should act
independent of loan officers and report
directly to the CEO of the bank
120
The Credit Process
 Credit Execution and Administration
 Problem

Loans
Often require special treatment
 Modify terms of the loan agreement to
increases the probability of full repayment
 Modifications might include:
 Deferring interest and principal
payments
 Lengthening maturities
 Liquidating unnecessary assets
121
Characteristics of Different Types
of Loans
 UBPR Classifications
 Real
Estate Loans
 Commercial Loans
 Individual Loans
 Agricultural Loans
 Other Loans and Leases in Domestic
Offices
 Loans and Leases in Foreign Offices
122
Characteristics of Different Types
of Loans
 Real Estate Loans
 Construction
and Development Loans
 Commercial Real Estate
 Multi-Family Residential Real Estate
 1-4 Family Residential
 Home Equity
 Farmland
 Other Real Estate Loans
123
Characteristics of Different Types
of Loans
 Real Estate Loans
 Commercial

Real Estate Loans
Typically short-term loans consisting
of:
 Construction and Real Estate Development
Loans
 Land Development Loans
 Commercial Building Construction and
Land Development Loans
124
Characteristics of Different Types
of Loans
 Real Estate Loans
 Commercial Real Estate Loans
 Construction Loans
 Interim financing on commercial, industrial,
and multi-family residential property

Interim Loans
 Provide financing for a limited time until
permanent financing is arranged

Land Development Loans
 Finance the construction of road and public
utilities in areas where developers plan to
build houses
 Developers typically repay loans as lots or
homes are sold
125
Characteristics of Different Types
of Loans
 Real Estate Loans
 Commercial

Real Estate Loans
Takeout Commitment
 An agreement whereby a different lender
agrees to provide long-term financing after
construction is finished
126
Characteristics of Different Types
of Loans
 Real Estate Loans
 Residential

Mortgage Loans
Mortgage
 Legal document through which a borrower
gives a lender a lien on real property as
collateral against a debt

Most are amortized with monthly
payments, including principal and
interest
127
Characteristics of Different Types
of Loans
 Real Estate Loans
 Residential Mortgage Loans
 1-4 Family Residential Mortgage Loans
 Holding long-term fixed-rate mortgages can
create interest rate risk for banks with loss
potential if rates increase
 To avoid this, many mortgages now provide
for:
 Periodic adjustments in the interest rate
 Adjustments in periodic principal payments
 The lender sharing in any price
appreciation of the underlying asset at sale
 All of these can increase cash flows to the
lender when interest rates rise
128
Characteristics of Different Types
of Loans
 Real Estate Loans
 The

Secondary Mortgage Market
Involves the trading of previously
originated residential mortgages
 Can be sold directly to investors or
packaged into mortgage pools
129
Characteristics of Different Types
of Loans
 Real Estate Loans
 Home

Equity Loans
Second Mortgage Loans
 Typically shorter term than first mortgages
 Subordinated to first mortgage

Home Equity Lines of Credit (HELOC)
130
Characteristics of Different Types
of Loans
 Real Estate Loans
 Equity Investments in Real Estate
 Historically, commercial banks have been
prevented from owning real estate except
for their corporate offices or property
involved in foreclosure
 Regulators want banks to engage in
speculative real estate activities only
through separate subsidiaries
 The Gramm-Leach-Bliley Act of 1999
allowed for commercial banks and savings
institutions to enter into the merchant
banking business
131
Characteristics of Different Types
of Loans
 Commercial Loans
 Loan
Commitment/Line of Credit
Formal agreement between a bank and
borrower to provide a fixed amount of
credit for a specified period
 The customer determines the timing of
actual borrowing

132
Characteristics of Different Types
of Loans
 Commercial Loans
 Working

Capital Requirements
Net Working Capital
 Current assets – Current liabilities
 For most firms, net working capital is
positive, indicating that some current
assets are not financed with current
liabilities
133
Characteristics of Different Types
of Loans
 Commercial Loans
 Working

Capital Requirements
Days Cash
 Cash/(Sales/365)

Days Receivables
 AR/(Sales/365)

Days Inventory
 Inventory/(COGS/365)
134
Characteristics of Different Types
of Loans
 Commercial Loans
 Working

Capital Requirements
Days Payable
 AP/(Purchases/365)

Days Accruals
 Accruals/(Operating Expenses/365)
135
Characteristics of Different Types
of Loans
 Commercial Loans
 Working

Capital Requirements
Cash-to-Cash Asset Cycle
 How long the firm must finance operating
cash, inventory and accounts receivables
from the day of first sale

Cash-to-Cash Liability Cycle
 How long a firm obtains interest-free
financing from suppliers in the form of
accounts payable and accrued expenses to
help finance the asset cycle
136
137
Characteristics of Different Types
of Loans
 Commercial Loans
 Working
Capital Requirements
138
Characteristics of Different Types
of Loans
 Commercial Loans
 Seasonal
versus Permanent Working
Capital Needs
All firms need some minimum level of
current assets and current liabilities
 The amount of current assets and
current liabilities will vary with
seasonal patterns

139
Characteristics of Different Types
of Loans
 Commercial Loans
 Seasonal
versus Permanent Working
Capital Needs

Permanent Working Capital
 The minimum level of current assets minus
the minimum level of adjusted current
liabilities
 Adjusted Current Liabilities
 Current liabilities net of short-term
bank credit and current maturities of
long-term debt
140
Characteristics of Different Types
of Loans
 Commercial Loans
 Seasonal
versus Permanent Working
Capital Needs

Seasonal Working Capital
 Difference in total current assets and
adjusted current liabilities
141
Characteristics of Different Types
of Loans
 Commercial Loans
 Seasonal Working Capital Loans
 Finance a temporary increase in net
current assets above the permanent
requirement
 Loan is seasonal if the need arises on a
regular basis and if the cycle completes
itself within one year
 Loan is self-liquidating if repayment
derives from sales of the finished
goods that are financed
142
143
Characteristics of Different Types
of Loans
 Commercial Loans
 Short-Term

Commercial Loans
Short-term funding needs are financed
by short-term loans, while long-term
needs are financed by term loans with
longer maturities
144
Characteristics of Different Types
of Loans
 Commercial Loans
 Open Credit Lines
 Used to meet many types of temporary
needs in addition to seasonal needs
 Informal Credit Line
 Not legally binding but represent a promise
that the lender will advance credit

Formal Credit Line
 Legally binding even though no written
agreement is signed
 A commitment fee is charged for making credit
available, regardless of whether the customer
actually uses the line
145
Characteristics of Different Types
of Loans
 Commercial Loans
 Asset-Based

Loans
Loans Secured by Accounts Receivable
 The security consists of paper assets that
presumably represent sales
 The quality of the collateral depends on the
borrower’s integrity in reporting actual
sales and the credibility of billings
146
Characteristics of Different Types
of Loans
 Commercial Loans
 Asset-Based Loans
 Loans Secured by Accounts Receivable
 Accounts Receivable Aging Schedule
 List of A/Rs grouped according to the
month in which the invoice is dated
 Lockbox
 Customer’s mail payments go directly to a
P.O. Box controlled by the bank
 The bank processes the payments and
reduces the borrower’s balance but
charges the borrower for handling the
items
147
Characteristics of Different Types
of Loans
 Commercial Loans
 Highly

Levered Transactions
Leveraged Buyout (LBO)
 Involves a group of investors, often part of
the management team, buying a target
company and taking it private with a
minimum amount of equity and a large
amount of debt
 Target companies are generally those
with undervalued hard assets
148
Characteristics of Different Types
of Loans
 Commercial Loans
 Highly Levered Transactions
 Leveraged Buyout (LBO)
 The investors often sell specific assets or
subsidiaries to pay down much of the debt
quickly
 If key assets have been undervalued, the
investors may own a downsized company
whose earnings prospects have improved
and whose stock has increased in value
 The investors sell the company or take it
public once the market perceives its
greater value
149
Characteristics of Different Types
of Loans
 Commercial Loans
 Highly

Levered Transactions
Arise from three types of transactions
 LBOs in which debt is substituted for
privately held equity
 Leveraged recapitalizations in which
borrowers use loan proceeds to pay large
dividends to shareholders
 Leveraged acquisitions in which a cash
purchase of another related company
produces an increase in the buyer’s debt
structure
150
Characteristics of Different Types
of Loans
 Commercial Loans
 Highly Levered Transactions
 An HLT must involve the buyout,
recapitalization, or acquisition of a firm
in which either:
1. The firm’s subsequent leverage ratio
exceeds 75 percent
2. The transaction more than doubles the
borrower’s liabilities and produces a
leverage ratio over 50 percent
3. The regulators or firm that syndicates the
loans declares the transaction an HLT
151
Characteristics of Different Types
of Loans
 Commercial Loans
 Term

Commercial Loans
Original maturity greater than 1 year
 Typically finance:
 Depreciable assets
 Start-up costs for a new venture
 Permanent increase in the level of
working capital
152
Characteristics of Different Types
of Loans
 Commercial Loans
 Term

Commercial Loans
Lenders focus more on the borrower’s
periodic income and cash flow rather
than the balance sheet
 Term loans often require collateral, but this
represents a secondary source of
repayment in case the borrower defaults
153
Characteristics of Different Types
of Loans
 Commercial Loans
 Term

Commercial Loans
Balloon Payments
 Most of the principal is due at maturity

Bullet Payments
 All of the principal is due at maturity
154
Characteristics of Different Types
of Loans
 Commercial Loans
 Revolving Credits
 A hybrid of short-term working capital
loans and term loans
 Typically involves the commitment of
funds for 1 – 5 years
 At the end of some interim period, the
outstanding principal converts to a term
loan
 During the interim period, the borrower
determines how much credit to use
 Mandatory principal payments begin once
the revolver is converted to a term loan
155
Characteristics of Different Types
of Loans
 Agricultural Loans
 Proceeds are used to purchase seed,
fertilizer and pesticides and to pay other
production costs
 Farmers expect to repay the debt with the
crops are harvested and sold
 Long-term loans finance livestock,
equipment, and land purchases
 The primary source of repayment is cash
flow from the sale of livestock and
harvested crops in excess of operating
expenses
156
Characteristics of Different Types
of Loans
 Consumer Loans
 Installment

Require periodic payments of principal
and interest
 Credit
Card
 Non-Installment

For special purposes
 Example: Bridge loan for the down
payment on a house that is repaid from the
sale of the previous house
157
Characteristics of Different Types
of Loans
 Venture Capital

A broad term use to describe funding
acquired in the earlier stages of a firm’s
economic life
Due to the high leverage and risk involved
banks generally do not participate directly
in venture capital deals
 Some banks have subsidiaries that
finance certain types of equity
participations and venture capital deals,
but their participation is limited

158
Characteristics of Different Types
of Loans
 Venture Capital
 Venture
capital firms attempt to add
value to the firm without taking
majority control

Often, venture capital firms not only
provide financing but experience,
expertise, contacts, and advice when
required
159
Characteristics of Different Types
of Loans
 Venture Capital
 Types

of Venture Financing
Seed or Start-up Capital
 Early stages of financing
 Highly levered transactions in which the
venture capital firm will lend money for a
percentage stake in the firm
 Rarely, if ever, do banks participate at
this stage
160
Characteristics of Different Types
of Loans
 Venture Capital
 Types of Venture Financing
 Later-Stage Development Financing:





Expansion and replacement financing
Recapitalization or turnaround financing
Buy-out or buy-in financing
Mezzanine financing
Banks do participate in these rounds of
financing, but if the company is
overleveraged at the onset, the banks will
be effectively excluded from these later
rounds of financing
161