April 6

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April 6

• Current events
• Credit risk

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Credit Risk
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Types of Loans

• Commercial and Industrial
• Real Estate
• Construction
• Residential 1 to 4
• home equity
• other
• residential 5
• Commercial (nonfarm, nonresidential)
• Farmland
• Agr. production
• Consumer (loans to individuals)
• credit card
• other
• Loans to other depository institutions
• Loans to small businesses

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Analysis of Credit RiskBank Reports

• Loan schedule
• Income statement measures
• Nonperforming assets
• Charge-offs
• Maturity and repricing loan data
• Derived revenues
• income statement values for specific categories
  divided by quarterly average loan volume

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Busey Bank Loan Portfolio
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Real Estate Loans
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Busey Bank 6/98Maturity/Repricing of Loan
Portfolio
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Busey BankNonperforming Assets
9
Busey BankCharge Offs
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Terminology

• Secured vs. unsecured
• Wholesale vs. retail
• Loan commitment
• Adjustable rate mortgages (ARMs)
• Revolving loan
• Loan covenants
• Compensating balances
• Legal lending limits
• Regulatory Requirements
• reasons for denial (Reg. B)
• truth in lending (Reg. Z)
• Loan syndications

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Truth in Lending(key disclosures)

• the amount financed
• the finance charge
• annual percentage rate
• payment schedule
• total of payments
• security interest information

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Borrower Evaluation
Reject
Accept
Loan Terms
Comply withConsumer Protection Laws?

• amount
• price
• collateral
• maturity
• fixed vs. variable interest rate
• covenants
• others

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Credit Risk Evaluation
Ability to Pay

• 5 Cs of Credit
• Character
• Capacity
• Collateral
• Capital
• Condition

CreditRisk
Willingness to Pay
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Commercial Lending

• Competitive environment
• banks
• credit unions
• insurance companies
• credit unions
• investment bankers
• stocks
• bonds
• commercial paper

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Managing Credit Risk

• Avoid high risk loans
• Reduce risk by evaluating credit worthiness
• Monitor the behavior of borrower
• Transfer credit risk by selling loans in
  secondary markets
• Diversify the loan portfolio.

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The Financing Mix
Firms Total Assets

Temporary Short term Line of credit
Temporary Assets
Permanent Revolving CreditTerm Loans
Permanent Assets
time
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Written Loan Policy

• establish general guidelines and principles for
  lending activities
• outlines banks lending objectives in terms of
  profitability and risk
• loan supervision

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Example Lending Authorities
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Written loan policy, cont.

• geographical limits
• credit policies
• administration
• types of desirable and undesirable loans
• collateral
• documentation
• procedures for collecting past dues
• charge offs
• overdrafts
• participations

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Ways banks make loans

• solicit loans
• buying loans
• commitment
• refinancing
• loan brokers
• customers request loans

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Process

• loan request
• business plan
• financial data
• initial interview

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Character

• credit records
• credit bureaus
• credit agencies (Dun and Bradstreet)
• other banks
• character check -- fraud

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Capacity

• Financial condition and ability to pay
• Credit analysis
• nature of business
• historical statements
• pro-forma statements
• fundamental assumptions
• realistic
• scenario analysis
• sensitivity analysis
• contingencies
• ratio analysis

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Analysis

• Trends within firm
• Comparisons to other firms in the industry
• RMA
• Industry analysis

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Collateral

• Assets pledged for security
• Characteristics of good collateral
• standardization
• durability
• identification
• marketability
• stability of value

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Types of Collateral

• Accounts receivable
• pledging
• factoring
• Inventory
• floating lien
• trust receipts (floor planning)
• chattel mortgage (security agreement)
• title registered with government authority
• warehouse receipts
• terminal warehouse
• field warehouse
• marketable securities
• natural resources
• real property and equipment
• guarantees

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Capital

• book value
• market value
• liquidation value

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Conditions

• External factors
• tax laws
• regulations
• import restrictions
• technology

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Compliance

• environmental laws
• CRA (community reinvestment act)
• compliance officers

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Structuring Loan Agreement

• Elements
• the amount borrowed
• the method of repayment
• the fees to be paid

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Credit Scoring and Credit Evaluation
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Numerical Credit Scoring

• Mathematical rules/formulas/model that can be
  used to assess default risk on loans
• Typically based on historical ratios
• Credit bureau ratings

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Motivations

• improve operating efficiency
• improve credit risk management
• price loans
• used by lenders unfamiliar w/industry

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Uses

• make loan acceptance decisions
• more equitable loan pricing
• monitoring of existing loans
• quality appraisals of loan portfolios

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History

• 1950s, Bill Fair and Earl Isaac
• Housing last 10 years
• MBS analysts
• Small business and agricultural lenders

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OCC Statement

• Shorten processing time
• Help lenders control risk
• Manage credit losses
• Evaluate new programs
• Improve lender profitability
• Cautions
• consistent implementation
• use on appropriate products

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Basic framework

• Identify key variables that represent a
  borrowers credit risk
• Select the appropriate measures for each variable
• Weigh the measurements according to relative
  importance
• Assign the credit score to the appropriate credit
  class for loan acceptance, pricing, monitoring
  and so on.

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Use of credit repositories

• Equifax Beacon Score
• Experian (TRW) FICO
• Trans Union Emperica Score

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• range 365 to 850
• typically need score gt 660
• assured if greater gt 700
• number of credit lines
• level of credit line usage
• length of history
• derogatory items
• past bankruptcy
• number of credit inquiries

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Limitations

• Implementation of model
• Quality of information
• Accounting issues
• Variation of businesss types/characteristics
• Standardization issues
• Collateral??

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Sample Models
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Sample Small Business Credit Scoring Model
Characteristic Value and Weights
Variable
Measure
Profitability
Return on equity
lt 0
0-4
5-9
10-14
15-19
gt20
score
0
1
2
3
4
5
Liquidity
Current ratio
lt 0.50
0.50-0.99
1.00-1.49
1.50-1.99
2.00-2.49
gt 2.50
score
0
2
4
6
8
10
Solvency
Debt-to-equity ratio
gt 2.50
2.00-2.49
1.50-1.99
1.00-1.49
0.50-0.99
lt 0.50
score
0
2.5
5
7.5
10
12.5
Repayment capacity
Term debt coverage ratio
lt 0.50
0.50-0.99
1.00-1.49
1.50-1.99
2.00-2.49
gt 2.50
score
0
2.5
5
7.5
10
12.5
Collateral
Secured assets/max loan
lt 1.00
1.00 -1.19
1.20-1.39
1.40-1.59
1.60-1.79
gt 1.80
score
0
2
4
6
8
10
Score
Credit Class
0 - 9.99
Non-acceptable loan
10-19.99
Very High Risk Loan
20-29.99
High-Risk Loan
30-39.99
Intermediate-Risk Loan
40-50
Low-Risk Loan
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Suppose a small business has the following data
Measure
Value
Score
Return on equity
6
2
Current ratio
1.50
6
Debt to equity ratio
0.75
10
Term debt coverage ratio
1.75
7.5
Secured asset to max loan
1.50
6
Total score
31.5
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Suppose a small business has the following data
Measure
Value
Score
Return on equity
6
2
Current ratio
1.50
6
Debt to equity ratio
0.75
10
Term debt coverage ratio
1.75
7.5
Secured asset to max loan
1.50
6
Total score
31.5
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Example Credit Classification Model for an Small
Business Revolving Operating Loan.
Class 1 Criteria, Very Low Risk
Debt to equity must not be greater than 0.33
Current ratio must be 2.0 or greater
Operating funds to borrow must be less than 40
of projected gross revenue
Term debt repayment margin must be 1.5 or greater
Three year average equity change must be greater
than 15
Class 2 Criteria, Low Risk
Debt to equity must not be greater than 0.66
Current ratio must be 1.5 or greater
Operating funds to borrow must be less than 50
of projected gross revenue
Term debt repayment margin must be 1.25 or greater
Three year average equity change must be greater
than 9
Class 3 Criteria, Moderate Risk
Debt to equity must not be greater than 1.00
Current ratio must be 1.25 or greater
Operating funds to borrow must be less than 60
of projected gross revenue
Term debt repayment margin must be 1.1 or greater
Three year average equity change must be greater
than 6
Class 4 Criteria, High Risk
Debt to equity must not be greater than 1.50
Current ratio must be 1.1 or greater
Operating funds to borrow must be less than 70
of projected gross revenue
Term debt repayment margin must be 0.9 or greater
Three year average equity change must be greater
than 0
Class 5 Criteria, Very High Risk
Debt to equity must not be greater than 2.33
Current ratio must be 0.85 or greater
Operating funds to borrow must be less than 75
of projected gross revenue
Term debt repayment margin must be 0.8 or greater
Three year average equity change must be greater
than -6
Evaluation
All Class 1 borrowers receive base interest rate
All Class 2 borrowers receive base interest rate
0.50
All Class 3 borrowers receive base interest rate
1.00
All Class 4 borrowers receive base interest rate
1.50
All Class 5 borrowers or below are not normally
considered a new credit.