CHAPTER-10 The bank Credit Organization -The main objective of the bank is not to making deposit and making loans, but to minimize risk in collection them. Thus the true core of business of banking is the profitable management of risk. -Banking crisis have occurred when a group of banks create loans of poor quality. Banks might get in trouble because of insufficient liquidity, unexpected interest rate movements, and so forth. But when banks fail, they do so because of poor-quality loans. -Lending is based on the two fundamental products of banking: money and information. - The trick is to create loan management packages and management systems that maximize banks chances of getting the money back.

The bank Credit Organization - Bank loans finance diverse group in the economy, manufacturers, farmers, builders, etc. which assist the society to grow, so the bank operations grow as well. -Every bank bears a degree of risk when it lends to private borrowers such as business and consumers with out exceptions, so banks experiences some loan losses when certain borrowers fail to repay their loans as agreed.

Loan Risk and Losses -Lending opportunities have been declined among low risk borrowers. Many conditions; such as high competition, have pushed banks toward riskier classes of borrowers. Most bank shift from large and stable corporate borrowers who engaged in the financial markets, to business with small, less stable borrowers. -poor quality loan was the main factor in the large number of faileures banks

Loan Risk and Losses-con It was noted that several faults in lending procedures include the followings: 1.Inattention to loan policies. 2.Overlay generous loan terms and lack of clear standards. 3.Disregards of banks own policies. 4.Unsafe concentration of credit. 5.Poor control over loan personnel. 6.Loan growth beyond the banks ability to control quality. 7.Poor systems for detecting loan problems. 8.Lack of understanding of borrowers cash needs. 9.Out-of- market lending.

Managing Credit Risk Credit Philosophy and Culture -Managing credit risk requires a clear credit philosophy in order to set management's priorities with respect to the marketplace. -Bank credit philosophy may range from an emphases on consistent performance of the highest quality loan portfolio based on highly conservative underwriting standards to an emphasis on aggressive loan growth and market share with highly flexible underwriting standard.

Managing Credit Risk-con. -Credit philosophy and loan policy must be supported by credit culture. An effective credit culture exist when the actual behavior of every individual in the loan organization is closely aligned with managements priorities. - Credit culture is reflected in the loan organizations system and procedures that implement managements priorities and minimize errors and poor lending decisions.

Managing Credit Risk-con. Credit Risk management Strategy Bank must design its credit risk management strategy. Figure P.393, illustrates the structure of bank credit risk. Overall credit risk is divided into two basic parts: 1.Transaction risk. 2.Portfolio risk. -Transaction risk includes selection risk, underwriting risk, and operations risk. -Portfolio risk is divided into intrinsic risk and concentration risk. Operation risk is considered in this chapter. The main objective is to explain the need for and the formulation of a loan policy to steer bank toward the desired makeup and control of their loan portfolios

The Credit Organization The organizational structure of the lending function varies with a banks size and type of business. -An officer of a small bank may perform all of the detailed work associated with making a loan. -in a large banks, individual officers specialize in consulting and negotiating with customers. Figure P.394.

The Credit Organization-con. Loan Division Figure 10.4 shows the various loan divisions. They perform the basic functions of generating loan business and supporting customers. Credit department -The primary mission of the credit department is to evaluate the creditworthiness and debt payment capacity of present loan customers and new loan applicants. -The department is an excellent place to train new loan officers. -the department may be responsible for loan review. -also, it is responsible for collection of past-due loans.

The Credit Organization-con. Collateral and Note Department The main loan function is the perfection of the banks security interest in collateral offered in support of a loan. -the department also performs the discount function: monitoring and crediting of payments received on outstanding notes.

Loan committees and the Loan Approval Process Loan Committees Among several committees, two or three committees are involved with major credit decisions, they are: 1.An officers loan committee 2.Director loan committee 3.Special assets committee The above committees are commissioned to approve only those loans that confirm to loan policy. Loan above certain minimum sizes are examined by individual loan officers before the officers loan committee:

Loan committees and the Loan Approval Process-con. this committees duties are: 1.Review major new loans 2.Review major loan renewals and ascertain the reasons for the renewal. 3.Review delinquent loans and determine the cause of delinquency. 4.Ensure compliance with stated bank policy. 5.Ensure full documentation of loans 6.Ensure consistency in the treatment of loan customers.

Loan committees and the Loan Approval Process-con. 1-The officer committee meet frequently- daily in large banks, and weekly in small banks. -the committee serve as check on of loans not as a substitute for the individual loan officers judgment. 2-The directors loan committee reviews major loans approved by the officers committee. The committee makes the final judgment on the officers loan committee decisions. It is concerned with conformance to bank loan policy and avoidance of violating law and policies control insider loans.

Loan committees and the Loan Approval Process-con. 3- a special assets committee: it is special committee. It is created in banks that have experienced a significant increase in regulator-criticized loans. It monitor the progress of problem loans, and try to find the best way to collect such loans. Loan Approval Process The loan approval process requires three elements: 1.Delegation of authority. 2.Uniform presentation format and standard. 3.The actual loan decision.

Loan committees and the Loan Approval Process-con. Some bank adopt decentralization process, which permits large loan limits to the loan officers, and possible for the officers to combine their limits with other officers. This system results in greater customers responsiveness and productivity. Some other banks grant smaller loan limits, do not permit combining of loan limits. This system has the advantage of greater consistency and safty.

Loan committees and the Loan Approval Process-con. Uniform presentation format and standards. Loan committee use a single standardized cover sheet that summarizes the key elements of the loan decision. Attachments to cover sheet include spread sheets, balance sheet and other projections, credit analysis and comment by the loan officer. The cover sheet should present brief comments on the following:

Loan committees and the Loan Approval Process-con. 1.Description of the clients business and position in its market and industry. 2.Assessment of management. 3.Purpose of the loan request 4.Repayment schedule and source of repayment. 5.Secondary sources of repayment including collateral values and guarantors. 6.History of past borrowing with the bank 7.Required monitoring steps, including timing of submission of financial statements 8.Sponsoring officers comments, including consistency with policy.

Loan committees and the Loan Approval Process-con. The Loan Decision Most loans presented to the loan committee receive approval, because officer submits all required information and job has been carefully studied. Loan committees frequently can improve the transaction by discussing the loan merit.

Loan Policy and Procedures Formulation Loan Policy All loans should reflect the banks policy loan. Such policy should reflect the bank lending philosophy and culture, indicating: Priorities Procedures Means of monitoring lending activity. Bank policy must be written in a written form. From the comptrollers point of view, a written policy should obtain three results:

Loan Policy and Procedures Formulation-con. 1.Produce sound and collectible loans. 2.Provide profitable investment of bank funds. 3.Encourage extensions of credit that meet the legitimate needs of the banks market. -Loan policy may change over time (different kind of loans may be lend according to environment of the market, such as consumer goods or capital goods. -loan policy vary over time; i.e.., in recession and boom periods. In periods of tight money, banks are able to expand lending rapidly and may have to restrict their loan growth. In contrast, when funds are plentiful and the economy is weak, banks may require their borrowers to show greater balance sheet and earnings strengths than during boom periods.

Loan Policy and Procedures Formulation-con. Loan Policy Outline The elements of written loan policy are as follows: 1.Introduction 2.Objectives 3.Strategies 4.Lending authorities and approvals 5.Credit standards According to the credit standards, the written policy states the desirable loans as following:

Loan Policy and Procedures Formulation-con. 1.Short term credit which include short-term loans to business customers such as working capital loans (30-90 days a year) 2.Undesirable loans such as loans of acquiring a business or to buy out stockholders in the borrowers present business. Such lending is considered as replacing equity with debt. Bridge loans are cited as a contrary to bank policy. 3.Speculative loans are proscribed by policy unless the borrowers can qualify independently on the base of his normal business performance. 4.Trade area. Primary and secondary area should be stated by the loan policy; such as the area be served, limits on loans participation out of the bank area, and exception of some loans. 5.Acceptable collateral 6.Appraisals.

Loan Policy and Procedures Formulation-con. Principles and Procedures They are organized into two parts: (p. 401) 1.Technical procedures 2.The detailed procedures and parameters. Some considerations are given her to some of the first part: Insurance protection The ability of borrowers to repay the loan is associated with risk. Life insurance on key personnel is necessary to protect against loss caused by death or any reason (flood, natural disasters, which destroy loan collateral.

Loan Policy and Procedures Formulation-con. The procedures policy should indicate: 1.The types of the borrowers who must be insured. 2.Designating the bank as loss payees. Documentation Standards Standards documentation must be followed in terms if uniform credit files. These standards are not the sale all sizes of the banks. Such requirements are routine for medium and large sized banks. Small bank might adopt what is preferred by the individual loan officers. The uniform loan documentation checklist is required for each file. They are; (see page 402) 12 requirements.

Controlling Loan Losses Securing Collateral Collaterals are used to protect the debit, so the bank has a right to sell the collaterals assets and use the money to repay the loan as agreed. Short run loan of high-quality borrowers are not secured, while most long-run loans are secured. Different kinds of collaterals are used to secure loans such as: -Real estate property (land and improvements, including structures). -Personal Property in the banks Possessions. -Personal Property in the customers possession (collateral property held by the borrower with a public filing of general security agreement, which grant the bank a security interest. Figure 10.5 p.404

Controlling Loan Losses-con. The Loan review Function -Bad loan may occur in the process of making loans. Most banks conduct loan reviews to reduce losses and monitor loan quality. -Credit analysis in loan review occurs after the loan is on the book. To reduce loan losses, the following points should be emphasized in loan review: To detect or actual or potential problem loans as early as possible. To provide an incentive for loan officers to monitor loans and to report deterioration in their own loans. To enforce uniform documention.

To ensure that loan policies, banking laws, and regulations are followed. To inform management and the board about the overall condition of the loan portfolio. To aid in establishing loan loss reserves. Loan Review Procedures These procedures should be in written form in the loan policy. Large size bank establish separate staff for loan review which independent from loan personnel. In midsize bank, such review is the responsibility of credit department or audit department. Small banks often they do not have review program or they depend on loan officers to do the job.

Conducting loan review required to cover the following points: Financial condition and repayment ability of the borrower. Completeness of documentation Consistency with the loan policy Perfection of the security interest on collateral Legal and regulatory compliance Apparent profitability Correcting Problem loans Some borrowers experience some difficulties to repay the loans, such difficulties describe the problem loans. The best way to conduct such problem is that individual loan officers can deal with such environment, because they have special rapport with their borrowers. Business deterioration can be noted by loan officers. Bad attitude toward loan officer is another clue of problem loans. Late payment of principal and interest and abnormal delay in submitting financial statements as required is another clue of problem loan (indicators of trouble p.407).