COMMERCIAL BANK OPERATIONS CHAPTER 13

Loans Copyright© 2006 John Wiley & Sons, Inc. 2 Loans are very profitable to banks, they take time to arrange,are subject to greater default risk and have less liquidity than most bank investments. Most bank loans consist of promissory notes.A promissory note is unconditional promise made in writing by the borrower to pay the lender a specific amount of money at specified future date.Repayment could be in periodic installmenst,in single amount or on demand.

Copyright© 2006 John Wiley & Sons, Inc. 3 Bank loans may be secured or unsecured, however most are secured that is are backed by a collateral. Banks make either fixed or floating rate loans. The interest on floating loans is periodically adjusted to changes in a selected short term rate usually a Treasury rate or LIBOR. If interest rates are unstable banks prefer to make floating rate loans. However, most bank loans carry fixed rates.

Major categories of bank loans: Copyright© 2006 John Wiley & Sons, Inc. 4 Bridge loan: supplies cash for specific transaction with repayment coming from an identifiable cash flows. Seasonal Loan: financing for temporary discrepancies between business revenues and expenses because of manufacturing or sales cycle of business. Long- term assets: loans to finance purchase of assets.

Copyright© 2006 John Wiley & Sons, Inc. 5 Loans to Depository Institutions: have variety of maturities and can be for variety of purposes. Real Estate Loans : finance purchase, construction of both residential housing and commercial facilities. Agricultural Loans: both short and long term loans for farmers. Consumer Loans: to individuals and their maturities and conditions vary. Bank Credit Cards.

Lease Financing Copyright© 2006 John Wiley & Sons, Inc. 6 Banks purchase the property on customer’s request and the lease it (rent) to the customer. Fast-growing line of business for large banks. Main economic justification is taxation. Common financing technique for— “fleet assets” (aircraft, ships, etc.) “rolling stock” (trucks, rail cars, etc) other capital equipment (cranes, generators, etc.)

Key considerations in loan pricing Copyright© 2006 John Wiley & Sons, Inc. 7 Earn a high enough interest rate to cover the cost of loanable funds Recover administrative costs of originating and monitoring the loan Provide adequate compensation for risk— Credit (or default) risk Liquidity risk Interest rate risk

Loan Pricing: One of the most important management decisions in banking Copyright© 2006 John Wiley & Sons, Inc. 8 Some key considerations The “Prime Rate” Base rate pricing Non-price adjustments Matched-funding loan pricing

The “Prime Rate” Copyright© 2006 John Wiley & Sons, Inc. 9 Historically a benchmark rate The lowest loan rate posted by commercial banks The rate banks charged their most creditworthy customers Other borrowers were typically charged some spread above prime Recently, the role of the prime rate has changed Over the last 20 years, fewer loans have been priced using “prime” Now, lenders choose among several other benchmark rates: LIBOR—“London Interbank Offered Rate” Treasury rates Fed Funds rate

Base rate pricing: marking up from a minimum offered the least risky borrowers Copyright© 2006 John Wiley & Sons, Inc. 10 Possible base rates: Prime, LIBOR, Treasury, Fed Funds Markups include three adjustments: For increased default risk For term-to-maturity For competitive factors—a customer’s access to alternatives r L = BR + DR + TM + CF where: r L = individual customer loan rate BR = the base rate DR = adjustment for default risk above base-rate customers TM = adjustment for term-to-maturity CF = competitive factor

Example Copyright© 2006 John Wiley & Sons, Inc. 11 Bank base rate is 7%,two customers a small firm and a large firm want loans. The large firm is well known nationally, has sold commercial paper on occasion, and wants a floating rate loan. The smaller firm wants a 1 year fixed rate loan.1 year T. securities sell for 0.75% above 3 month T-bill. Pricing FactorSmall FirmLarge Firm Base rate7% Default risk adjustment 3%2% Term to maturity adjustment 0.75%0.00 Competitive factor adjustment 1%0.00 Loan rate11.75%9.00%

Copyright© 2006 John Wiley & Sons, Inc. 12 Compensating balances- - Bank requires borrower to carry minimum balance in non- interest-bearing deposit account; e.g. loan is $100,000 then you have to maintain 10,% as deposit in the bank that is $10,000. Matched Funding: A way to control interest rate risk of fixed rate loans by financing them with deposits of the same maturity. e.g. Bank gives1 year fixed rate loan, can be financed with 1 year CD.

Analyzing, managing, and pricing credit risk Copyright© 2006 John Wiley & Sons, Inc. 13 Five “C”s of Credit: 1. Character (willingness to pay, credit history) 2. Capacity (projected cash flow) 3. Capital (wealth or net worth) 4. Collateral (security for the loan) 5. Conditions (economic conditions ) Credit scoring involves assigning a potential borrower score based on the information in the borrower’s credit report: 1. Payment history 2. Amount owed 3. Length of credit history 4. Extent of new debt 5. Type of credit in use

Copyright© 2006 John Wiley & Sons, Inc. 14 Advantages of credit scoring are it is efficient, inexpensive, gives fast decisions and minimizes discriminatory lending practices. While disadvantages, impersonal, does not allow for special circumstances and difficult for potential borrower to improve their score. Once the five C’s are analyzed a customer is assigned to a credit rating category and default risk premiums is determined for each risk categories.

Pricing deposits, the bank’s main source of loanable funds Copyright© 2006 John Wiley & Sons, Inc. 15 Must offer depositors high enough rates to attract and retain a stable deposit base Must not pay so much on deposits that profitability is compromised Competition puts pressure on the “spread” from both sides bank may have to charge lower rates on loans bank may have to pay higher rates on deposits