CREDIT ANALYSIS AND LENDING

MANAGEMENT
WEEK 1
INTRODUCTION
AND
UNDERSTANDING ANALYSIS AND MANAGING
CREDIT DECISIONS

BFW3841 S1 2018
Lecture Overview
 The Big Picture - Global, regional and local knowledge on the
economy, financial markets, financial institutions, the businesses
(corporates, SMEs and the people).
 Bank lending and management principles, tools and techniques
of credit evaluation, monitoring and risk management control.
 Credit problem analysis, identification and problem solving.

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 What Content Changes you can Expect?
 Changing economic, business, cultural and political environment;
 Regulatory and policy changes to credit rules, capital and
liquidity requirement, property and residential housing prices,
Basel III etc.
 Credit risk management and the policies.
 Monetary and fiscal policies that have bearings on credit decisions
and management.

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 Unit Course Objectives
The learning objectives of this course are to:

1) Apply appropriate analysis techniques to particular loan facilities

2) Analyse the risk return characteristics (and pricing) of a loan application

3) Examine the major types of lending products and gain the ability to
match these products to customer needs

4) Investigate the behavioural aspects of decision making and decision

makers

5) Describe statistical techniques used in decision making at the approval,

monitoring and termination stages of lending

6) Apply critical thinking, problem solving and presentation skills to

individual and /or group activities dealing with lending decisions and
demonstrate in individual summative assessment tasks the acquisition
of a comprehensive understanding of the topics covered by BFW3841.

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Unit References

 The textbook, Credit Analysis and Lending Management by

M. Sathye, J. Bartle, M. Vincent & R. Boffey will be the
primary resource.
 The other reference book used is Bank Management and
Financial Services (9th ed.), Rose, P. S., Hudgins, S, 2013
McGraw-Hill Irwin.
 Others posted on the Moodle.

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 Student Assessment
 Unit Assignment (Individual Assignment covering objectives 1,2,4 & 6) 30%
 15 Multiple Choice Questions in week 7 (Thursday, 19 April 2018) 10%
 Final Exam ( objectives 1- 6) 60%

 Unit Assignment:
The unit assignment for the semester will be posted on the Moodle.
Please comply to the deadlines and conditions of the unit assignment.

Due date: Week 9, Thursday, 3 May 2018 by 3.00 Noon.

 Late Submissions: Penalty of 10% per day of delay

 Warning : Plagiarism / Copying

http://www.policy.monash.edu.au/policy-
bank/academic/education/conduct/student-academic-integrity-managing-
plagiarism-collusion-procedures.html
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 LECTURES, TUTORIALS & CONSULTATION SCHEDULE
LECTURES Thursdays 12.00 PM – 2.00 PM Audi 2 (6117)
11.00 am – 12.00 noon
Mondays 12.00 noon – 1.00 pm ROOM 6509
2.00 pm – 3.00 pm
CONSULTATION
Tuesdays 11.00 am – 12.00 noon ROOM 6509

Thursdays 11.00 am – 12 noon ROOM 6509

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Assignment Assessment
 Term Paper
The term paper will be assessed on the basis of the following:
 Comprehensiveness, clarity, and conciseness - to assist
you in achieving this outcome you are strongly encouraged to
prepare a detailed outline of your paper before you begin to
write it.
 Incorporation of appropriate and relevant examples.
 Adequacy of references. You should rely mainly on
relatively recent articles in newspapers and business journals.
 While there is no length requirement, it should not exceed
3,000 words, double-spaced, including references, tables
and illustrations.

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 Week 1
SEMESTER 1, 2018

BFW 3841
Credit Analysis and Lending Management

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The Principles of Lending and Lending Basics
 Lecture 1 Objectives
 Identify the basic principles governing bank lending and explain their importance.
 Understand the framework within which credit and lending decisions are taken.
 Understand the business process in lending decision.
 Explain the characteristics of various types of bank advance.
 Distinguish different types of borrowers and any special considerations in lending.
 Explain how advances are structured.
 Explain the importance of credit culture in a lending institution.
 Understand how an advances portfolio is designed.

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CREDIT ANALYSIS AND LENDING MANAGEMENT
To comprehend credit analysis and lending management
 Must acquire knowledge of principles of lending.
 The principles of lending have evolved from practice over the
years.
 The lending discipline is based on a framework for sound credit
analysis and management.
 The lending principles have universal applications.
 The lending principles and framework allow for a systematic credit
analysis and decisions.
 Credit analysis and management is both an art and a science.

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 What is CREDIT?
 Credit can be described as monetary or monetary equivalent
transactions including non-monetary/or barter transactions.
 Credit can be define as “ A transaction between two parties in
which one party (creditor) provides money or monetary
equivalent in return for a promise of future payment by the other
party (debtor). The payment by the debtor would include the
payment of interest over and above the principal amount” (Joseph
Ciby, Credit Risk Analysis)

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 Importance of Credit Analysis and Lending
Management
The Role of Credit in an Economy
 Idle or surplus resources can be effectively put to good use by
extending credit to borrowers and entrepreneurs. Thus, spurring
economic growth of;
 the borrower / entrepreneur
 Well being of the community and society
 The nation.
Limiting Credit Loss
 Some debtors do not pay back the credit as promised leading to a
credit loss by the creditor.
 Sound credit analysis and management will limit credit loss to a
minimum for the creditor to be sustainable and provide a positive
return to the investor.
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PHASES in Credit Analysis and
Lending Management
 Three Phases

1. Origination of credit/loan

2. Funding of the credit/loan

3. Monitoring and Management of the credit/loan

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Enquiry Application Evaluation
• Customer Enquires • If Yes at the Enquiry stage • Analyze the credit worthiness
• existing customer • Receive application of the loan
• new customer • Register application • 6 C’s
• Assess customer suitability • Assign officer • Credit score
• Credit check, legal and • Site Visit
policy • Project evaluation – cash
• Decision YES/NO flows, profit and loss, IRR etc.
• If Yes, proceed to • Documents
application • Credit checks
• If No – either outright reject • Recommendations Yes/No
or reevaluate proposal

Decision Pre-disbursement
Documentation
• Loan Committees
• Loan & board • If Yes • Check on legal documents
• Decision Approved/ Not • Prepare legal documents properly executed and
Approved • Acceptance of letter of registered
• If Approved – Prepare letter offer • Make another credit check
of offer • Loan agreements • visit
• Security documents • Check with invoices
•Lodgments with registries • Check list complete
• Authorization to disburse

Disbursement Loan Closed

Monitoring
• Disbursement amount • Full settlement
• Loans monitored for compliance • Recovery/ foreclosure
Credited into account or and project progress
cheque issued procedures
• monitor repayment status • legal proceedings
• restructuring or rescheduling of loan • auction off land and
properties
• Bankruptcies 15

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Functions of Banks
 Liquidity intermediation
Reallocating all the money in excess, saved by depositors, in order to finance
companies short of cash and expanding through long-term investment plans
 Risk intermediation
A bank collects risks from the economy and reengineers them for the benefit
of all economic agents, e.g. securitization
 Information intermediation
There is asymmetric information between an entrepreneur(who has better
information about the riskiness of his project) and the uninformed savers and
investors from whom he is seeking financing.

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 The role of debt in the theory of the firm
 Funding for projects is supplied not only by cash flows generated by
the company but also by additional debt and/or equity. Debt and
equity offer very different payoff patterns, triggering off behaviours
by the claim holders.
 Debt holders are interested in the repayment of the principal and
interest
 If the value of the firm is below the principal (V<D), then debt
holders have priority over equity holders and seize the entire value
of the firm V.
 Equity holders have a zero payoff. However, if the value of the firm is
more than sufficient to repay the debt (V>D), the excess value (V-D)
falls into the hands of equity holders.
 Debt holder is not interested in the firm reaching very high levels V>>D,
the debt holders payoff remains the same.
 Conversely the higher the value of the firm, the better for the equity
holder.
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 The role of debt in the theory of the firm

 Since equity holders run the firm and make investment

and production decisions, the convexity of their payoff
with respect to the value of the firm induces them to
take on more risk in order to try and reach very high
levels of VALUE.
 If the project fails they are protected by limited liability and end
up with nothing.
 If the project succeeds then they extract most of the upside, net
of the repayment of the debt.

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 The role of debt in the theory of the firm
 Financial theory shows that optimal allocation of control
rights between debt holders and shareholders enables in
some cases the maximization of the value of the firm.
 There is also a fine tuning between equity and debt in
order to minimize the following two sources of
inefficiency:
• The asymmetry of roles between the uninformed lender and the
well-informed entrepreneur;
• Market intelligence – the incompleteness of contracts, leading
both parties to be unable to devise a contract that would express
the adequate selection rule as well as the rule for optimized
management of the project.
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 Impact of the Asymmetric Relationship between
Investors and Entrepreneurs
 An asymmetric relationship exists between the investor providing funding
and the entrepreneur seeking it:
 Asymmetry in initial wealth, asymmetry regarding the management of the
funded project and asymmetric information. The entrepreneur has
privileged private knowledge about the value of the project and how it is
managed.
 There are two major types of asymmetric information in microeconomic
theory:
• Adverse selection: Because of a lack of information, investors prove unable to
select the best projects. They will demand the same interest rate for all projects.
This will in turn, discourage holders of good projects and investors will be left
with the bad ones.
• Moral hazard: If an investor cannot monitor the efforts of an entrepreneur, the
latter can be tempted to manage the project suboptimal in terms of the value of
the firm. This lack of positive incentive is called ‘moral hazard’.
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 Principles of Good Lending
 Safety of Loan:
o Borrower should be of good character, financially sound with the
ability and willingness to repay the loan.
 Suitability of Loan Purpose:
o Loan applications may be accepted or rejected subject to bank
policy, legality and ethical principles.
 Profitability:
o The risks and returns from lending activities must be carefully
considered to improve viability of loan portfolio. Credit should be
priced so as to cover the cost of funds together with an
appropriate risk premium.
 Following the Lending Principles:
o Regardless of loan size, lending principles of varying levels of
sophistication must be rigorously adhered to.
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 Traditional Approach:
Principles of Good Lending: The “Six Cs”
 Character: the sum total of human qualities
 Capacity: the ability to fulfil financial promises
 Capital: the ‘owner’s margin or equity cushion
 Collateral: the borrower’s secondary source of repayment
 Conditions: the external and internal environments
 Compliance: Legal, procedure, policies etc.
Modern Approach:
Credit Risk Measurement:
 Statistical and mathematical tools such as credit scoring
 Econometric tools
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Principles of Bad Lending
 Complacency
 Carelessness
 Poor Communication
 Lack of Covenants
 Cut-throat Competition
 Failure to set Contingencies

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 Credit Analysis and Lending Decisions
– A Framework
 External Factors Affecting Lending Decisions:
o Legislation including common law, RBA Act, Banking Act,
Uniform Consumer Credit Code, ASIC Act and the ACCCs
consumer laws
o Macroeconomic factors
o Industry-specific factors
 Lending Institution-Specific Factors:
o Institution's lending policy, Loan Budget and Staff Availability
 Borrower-Specific Factors:
o Meeting “Six Cs” requirements and compliance with legal
requirements

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 Credit Classification
Traditional Types of Credit Classification
 Loans Classified According to:

Types of Credit Description

1 Security Secured or Unsecured

2 Borrower Personal, Business, Government etc.
3 Term/Tenure Short, Medium, Long
4 Sector Agriculture, Manufacturing, Services etc.

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 Credit Classification
 Traditional Types of Credit
 Loans Classified According to:
Classification Description
1 Region Rural, Town, City
2 Purpose Personal, Home, Commercial, Motor Vehicles
3 Products Overdraft, Hire purchase, Mortgage
Overdrafts:
Flexible form of fixed limit continuous loan with no fixed repayment schedule and
flexible drawdown characteristics

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 Grouping of Credit
Credit given can be broadly grouped into the following
classification
Classification
1 Real Estate
2 Financial Institutions loans
3 Agriculture loans
4 Commercial and Industrial loans
5 Loans to Individuals
6 Miscellaneous Loans
7 Lease Financing

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 Modern Forms of Business Lending:
o Equity Participation: equity rather than debt finance
o Loan Syndication: consortium of lenders provide funding
o Equipment Leasing: financing v. operating
o Hire Purchase : Purchase of automobiles, equipment and
consumer durables
o Factoring: sale of business’ debt (invoices)
o Bridging Finance
o Structured Finance
o Management Buyout ( mergers and acquisitions)
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Types of Borrower
 Personal:
 Unable to enter loan contract if:
X Minors - borrower under 18 years old
X Seniors - borrowers above 60 years old
X Persons of unsound mind
X Insolvents - bankrupts or insolvents who are either
undischarged or pending proceedings

 Joint Accounts: account held in the name of two or more

persons
 Husband and Wife
 Father and son

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Types of Borrower
 Business Borrowers:
Business Borrowers Description
1 Sole Proprietorship Operated by one person
2 Partnerships Business with more than one owner where
profits are shared
3 Companies Separate legal entity recognized under
Corporation Law; Public & Limited companies
4 Small and Medium SME’s
Enterprises
5 Micro Enterprises Very small businesses
6 Start-ups New businesses

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 Types of Borrower
 Special Types of Borrower:
Special Borrowers
1 Local Authorities
2 Clubs, Literary Societies,
Schools
3 Unincorporated Associations
4 Cooperatives
5 Professional Bodies
Description
Local governments, City councils
Generally registered as unincorporated
associations (registered with particular
agencies e.g. Registrar of Societies)
Arts, Charities, Religious
Registered under Cooperatives Societies
Act
Registered with Professional governing
bodies. CPA, ACCA, MIA
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Structuring of Loans
 Security/Collateral:
o Includes land, buildings, debentures, pledges, directors’
guarantees, shares, bill of sales, ownership claims, crop liens

 Debt Covenants:
o Outlines key loan conditions including fees, security,
repayments

 Pricing Issues:
o Risk premium over a benchmark rate

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Credit Culture
 Can be defined as:
o The institutional priorities, traditions and philosophies that
surround credit or lending decisions; and/or

o “The collection of principles, actions, deterrents and rewards

that exist within a lending organization” Caouette, Altman and
Narayanan (1998)

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Credit Culture / Ethics in Lending
The financial crisis in the United States in
2007/2008 was due in part to a culture where
hubris and self centered greed played significant
roles.

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 Credit rationing: Allocation of loans to creditworthy borrowers by other
than pure market means. Credit rationing occurs when interest rates are kept
below the level at which an unregulated market would set, leading to an
excess of demand for loans.
 The bank is a ‘price maker’:
o When banks’ competition is limited the banks are ‘price makers’ and
a bank can choose to increase interest rates in order to select the
best performing projects. Such a policy will penalize the best projects
first, leading banks to pick worse ones.
 The bank is ‘price taker’:
o A bank is not able to adjust its interest rates. The adjusted price is
based on market equilibrium. In this situation it has to reject some
projects because of return requirements. These requirements depend on
the average default rate in the bank portfolio, the size of the exposure
on each project, and the market interest rate compared with the
expected return of the bank.
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Designing a Credit Portfolio
 Advances portfolio design requires decisions
incorporating:
o What resources are available to invest?
o Of these, what proportion should be invested in
advances?
o What proportions should be invested in personal versus
business advances?
o Of those personal advances, what proportion should be
in housing loans, credit cards and so on?

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Designing a Credit Portfolio
 Three main approaches:
o Historical or recent loss experience

o Standards based on risk tolerance to capital

o Risk-adjusted return on capital, where risk is evaluated relative

to the risk either at the transaction level or business unit level.

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Summary
Banks act as financial intermediary by collecting deposits
and funds from the economy and channeling the funds to
investors and borrowers as loans. The process of making
decision on lending is beset with risks due to information
asymmetry, external and internal conditions and the
borrower characteristics. The tools, techniques and
methods employed in lending decision is becoming more
quantitative than qualitative. However, both methods are
necessary for sound lending decision

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 Next Week
 Legal Framework Lending.
 Understanding Basel II & Basel III

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CODE :

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