1. Canons of Lending Lecture Objectives
1.      To explain the canons of lending
2.  To discuss some significant points in commercial bank’s lending
3.      To explain the credit scoring system

2. Canons of Lending Introduction
The main interest income of commercial banks is derived from granting loans to customers. But lending is a risky business. The fundamentals of credit are the questions : How much money do you want to borrow? What do you want the money for? How long do you want the money for? And how will you repay the money?

3. Canons of Lending
Canons of lending means the general standards or the set of principles which any lending institutions would follow when processing credit facilities for their clients.

4. Purpose of the credit
The borrowing customer has to disclose to his banker the object of the borrowing. The bank must consider carefully whether the credit is most suitable to the borrower’s need. The bank will then assess whether the loan is to be used in any illegal activity or for speculative purposes. Most banks will decline loan proposals which are highly speculative. The bank is also concerned with whether the loan shall generate sufficient profit and cash flow desired by both the borrower and the banker in order to meet the repayment schedule.

5. Repayment schedule
The borrower must be able to service the debt, i.e. to pay interest and principal when due. The banker will examine, in general, the possible sources of income of the borrower, and in particular, determine whether there will be sufficient cash flow over the term of the loan to service the debt.

6. Repayment schedule
To support a loan application, a corporate customer is normally required to submit detailed financial statements that will substantiate his capability to generate adequate funds to repay the loan. The financial statements submitted by the customer include income statement, balance sheet and projection of cash flow and growth of the business. The banker will analyze the financial position of the borrower to assess the repayment capability.

7. Amount of the loan
The amount of the loan requested by the customer depends on his business capacity. In order to determine the precise amount to be borrowed, the banker may examine the corporate customer’s financial statements. They should provide the banker with some indications of the customer’s financial position. The bank will examine this information in determining the maximum amount to be made available to the customer.

8. Term of the loan
The term of the loan is an essential factor in assessing credit risk. The longer the term of the loan, the higher the risk exposure due to the increasing chance of unfavourable long-term economic and political changes. In this respect, the bank may tailor a loan repayment schedule in accordance with the customer’s financial planning and any possible risk. The bank should make some judgment on the future course of the economy and the political environment so that it is well prepared if, in fact, the expected risks materialize.

9. Credit risk assessment
Depending on the size of the loan, a banker should employ the credit risk assessment in order to determine the credit worthiness of potential customers.
(i)    Current risk assessment : evaluates possible economic and political risks.
(ii)     Potential risk of default assessment : involves the evaluation of the risks relating to the size of the credit and type of security provided by the customers.

10. Credit risk assessment
A bank would issue guidelines to staff responsible for loan applications concerning the maximum risk the bank should bear for any particular type of loan.

11. Market analysis
For commercial loans, whether the customer is able to make repayments according to the schedule depends largely on the profitability of the goods or services produced by the business. If a customer’s product is well received in the market, the turnover is likely to generate sufficient revenues, resulting in more profit available to repay the loan. Therefore, the banker must check the economic / market prospect of the goods / services the customer is producing.

12. Market analysis
In order to understand the operation of the borrowing company, the banker will visit the production plant or the operation site to make a judgment on the borrower’s experience, ability and integrity in running his business.

13. Pricing of loans
The bank has to calculate its own costs of providing loans to customers. In Hong Kong, most banks set the interest rate of loan at some percentage (margin) over the prime rate. The margin indicates the possible credit risk that a loan may bear. The higher the possible risk involved, the larger the margin over the prime rate to be charged to the loan. It depends on the size of the loan, the financial strength of the borrower and the nature of security offered by the customer.

14. Collateral
Collateral refers to security provided by a borrower to offset the apparent weaknesses of a loan, such as inadequate capital, certain risks and uncertainty arising from market conditions. Collateral should be considered as a protection rather than as a source of repayment. Collateral makes a loan safe but should be the last item to be considered in loan approval.

15. Character of the borrower
The character refers to the borrower’s determination to repay the loan; it can be assessed by examining his track record. A bank can obtain such information from credit card companies and other financial institutions. The questions to be considered are : Are there any bank records showing a new customer’s account performance? Is the borrower reliable in making repayment according to schedule? Is the borrower exaggerating his income or business conditions?

16. Capacity
The capacity indicates a customer’s ability, financial strength and legal capacity to borrow. Loans are generally not granted to minors. If the customer is a limited company, the bank has to examine the company’s memorandum and articles of association to ensure that it has the legal authority to borrow.

17. Capital
The capital is the cushion of assets for repayment of the bank’s advances in the event of the borrower experiencing financial difficulties. The banker should make sure that the borrower has sufficient capital to operate his business effectively and to meet keen competition in order to maintain his ability to make loan repayment. A strong capital base not only demonstrates the customer’s ability to repay his loans but also indicates his commitment to sustaining the production capability in securing future income.

18. Significant points to consider in processing loan proposals
It is safer to lend small amounts to many customers rather than large amounts to a few customers.
Try to find out as much credit information as possible from any sources about the customers.
Short-term loans bear less risks than long-term loans. To protect the bank, always stipulate the clause “repayment on demand” in the terms and conditions of the credit.

19. Significant points to consider in processing loan proposals
Whenever possible, the customer’s financial statements should be obtained and analyzed.
Make sure that the interest rate agreed with a customer reflects the degree of risk involved.
During the life of a loan, systematic and constant reviews of the account should be conducted, loan performance and repayment records should be carefully monitored.

20. Significant points to consider in processing loan proposals
Ascertain the value of a security and obtain safe title. Verify the genuine ownership of the security and make sure that the customer is not holding the security merely as a trustee.
Do not borrow short and lend long. Pay attention to the bank’s liquidity in comparison with the loan portfolios.

21. Significant points to consider in processing loan proposals
Never lend money solely against security even though its realizable value exceeds the loan amount. Banks are not pawnshops.

22. Cross-border Lending
If a bank decides to provide loans to customers in the international market, a country-risk and currency-risk assessment should be conducted to obtain information about a country’s political and economic risks as well as the currency’s foreign exchange risk. There should be appropriate approvals given by the foreign government and/or central bank, especially in a country of foreign exchange control and there is control of ownership in domestic assets which are used as security for the loans.

23. Credit Scoring System
Credit scoring is the measurement of the statistical probability that credit will be repaid. The technique involves awarding points to answers given by the prospective borrower to the questions listed on an application form. The questions cover such areas as :

24. Credit Scoring System (i) marital status and dependants (ii) age
(iii)    number of years living at the present address
(iv)   nature of the property occupied, i.e. self-owned or rented
(v)     occupation
(vi)    length of time with employer
(vii)   previous credit experience

25. Credit Scoring System
Each question will carry a maximum possible score which will be higher for important questions such as occupation and lower for less important questions such as marital status. The score awarded to each answer will vary : for example, if the question asks for the number of years living at the present address, one point might be awarded for each year, up to a maximum of 10 points.

26. Credit Scoring System
The questions are designed by the lending specialists of the bank with the guidelines as to how the credit staff should interpret the total score of an application. If the total score is above a certain number, the loan will be granted to the applicant.

27. Credit Scoring System
The technique of credit scoring can be used for all routine applications for opening a personal current account and granting overdraft or personal loan. It replaces the personal judgment by a scientific method but still most banks will carry out other checks, such as a search through a credit reference agency.

28. Credit Scoring System
As there is a need for banks to improve the accuracy of their credit assessment in view of the trend for banks to diversify their customer lending portfolio, the HKMA has been considering the concept of setting up a credit reference agency in Hong Kong. The sharing of credit information will enable financial institutions to make more informed assessments of their customers’ credit standing, and this should in turn improve the asset quality of financial institution.

29. Before the tutorial
Visit the library to find the Hong Kong Monthly Digest of Statistics and make a copy of the Loans and Advances for Use in Hong Kong by Economic Sector.
Discuss the lending situations of all the authorized institutions in Hong Kong.