Commercial and Industrial Lending

• Outline– The role of asymmetric information in lending

– The competitive environment

– The Board of Directors written loan policy

– Seven ways to make loans

– Principal lending activities

– Collateral

– The lending process

The role of asymmetric information in lending

• Asymmetric information and adverse selection– Inequality of information between the lender and borrower. Given

imperfect information is available to lenders, the average interest rate is too high for borrowers with low-risk investment projects, and too low for borrowers with high-risk investment projects.

– Adverse selection means that high-risk borrowers are willing to pay the average rate of interest, and low-risk borrowers are not willing to pay it. Thus, banks tend to attract higher than average borrowers before loans are made.

– Moral hazard occurs after a loan is made. The borrower has an incentive to engage in higher risk activities (to earn higher returns) at the expense of the bank.

– Banks must use effective monitoring to reduce adverse selection and moral hazard risks.

The competitive environment• The business of lending

– Profits on interest income and fee income.

– Earn higher profits by taking more risk.

– Credit risk can cause the borrower to default on loans causing losses to the bank (i.e., borrower has a put option on a loan).

• Increasing competition– Expectation of high returns attracts competition.

– Banks syndicate loans to compete with investment bankers to finance large firms.

– Nonbank lenders have increased their lending activities.

• Changes in technology– Securitization to package and sell otherwise unmarketable loans.

– Credit scoring to estimate the probability a borrower will default based on statistical/computer models (e.g., Fair Isaac -- see www.fairisaac.com).

– J.P. Morgan (1997) introduces CreditMetrics, a VAR approach to measuring credit portfolio risk. Other firms are developing VAR models.

The Board of Directors written loan policy

• The role of Directors– Provide guidelines and principles for the bank’s lending activities:

Loan authority, loan portfolio, geographic limits, pricing policies, off-balance sheet exposure limits, and loan review process.

• Reducing credit risk– Avoid making high-risk loans.

– Use collateral to reduce risk (i.e., secondary source of payment).

– Diversify by lending to different types of borrowers and avoiding undue concentration to a borrower or group of borrowers.

– Documentation needed to legally enforce a loan contract.

– Guarantees by third parties can reduce risk (e.g., the Small Business Administration assists small businesses with guarantees).

– Monitor the behavior of the borrower after the loan is made. Agency problems of lender to influence the behavior of the borrower.

– Transfer risk to other parties via securitization and loan participations.

Seven ways to make loans• Banks solicit loans (sales, cross-selling, etc.).

• Buying loans (participations with other banks -- when 3 or more unaffiliated banks make a loan in excess of $20 million, it is called a shared national credit).

• Loan commitments (an agreement between a bank and a firm to lend funds in the future based on agreed written terms).

• Customers request loans.

• Loan brokers (help arrange loans by approaching banks and other lenders with prospective loan deals with firms).

• Overdrafts (that occur when a customer writes a check on uncollected funds or there are insufficient funds).

• Refinancing of loans (due to lower loan rates).

Principal lending activities• Loans and leases for temporary assets versus permanent assets:

– Line of credit is a predetermined amount available to the firm upon request (under established terms and conditions). Normally for working capital needs or temporary assets for one year or less.

– Revolving line of credit is a guaranteed maximum amount of loans available to the firm. Normally for temporary assets but can be for more than 2 years.

– Term loan is a single loan for a stated period of time, or a series of loans on specified dates. Normally for permanent assets (e.g.,, machinery, building renovation, refinancing debt, etc.) and can be for more than 5 years. Value of loan should be less than value of asset, as borrower equity is positive (i.e., incentive to pay off the loan). Maturity of loan should not exceed the life of the asset.

– Bridge loan helps to finance working capital or other needs for a short period of time within which the firm is seeking alternative financing (e.g., a commercial paper issuance).

Principal lending activities• Loans and leases for temporary assets versus permanent

assets:– Asset-based lending is using the assets of the firm to secure a loan.

All secured loans can be classified as asset-based lending. Unlike regular C&I loans, greater weight is placed on the market value of the collateral. Also, greater monitoring of the existence, value, and integrity of collateral is performed than for other “secured” loans.

– Leasing is used to finance tangible assets, including cars, airliners, and ships. A lease contract enables the user -- lessee -- to secure the use of the tangible asset for a specified period of time by making payments to the owner -- lessor. Operating leases are short-term contracts, whereas financial leases are long-term with terms that equal the economic life of the asset.

Collateral• Definition: An asset pledged against the performance of an

obligation. – Does not reduce the risk of the loan per se (which is tied to ability of the

borrower to repay a loan and other factors).

– Reduces bank risk but increases costs of lending and monitoring.

– Characteristics of good collateral:Durability is the ability of the asset to withstand wear. Durable versus

nondurable collateral.

Identification due to physical uniqueness or serial numbers.

Marketability of the property if resold.

Stability of value over the period of the loan.

Standardization by government or industry guidelines in grading quality of assets.

Collateral• Types of collateral:

– Accounts receivable can be used by means of:Pledging wherein the firm retains ownership of the receivables and no

notification to the buyer of the goods.

Factoring wherein the receivables are sold to a factor such as a bank or finance company. The buyer now pays the factor for the goods. Factors usually buy receivables on a nonrecourse basis (so they cannot be returned to the seller by the bank).

Bankers’ acceptance to finance foreign goods in transit, which is an account receivable to the exporter. A time draft is created which must be paid by the importer when goods are finally delivered. The time draft becomes a negotiable instrument that can be traded in securities markets after the importer’s bank accepts it.

– Inventory

– Marketable securities

– Real property and equipment

– Guarantees by third parties (e.g., a U.S. government agency)

The lending process• Evaluating a loan request

– 6 C’s of credit:Character (personal traits and attitudes about commitment to pay debt)

Capacity (borrower’s success at running a business -- cash flows)

Capital (financial condition of the borrower -- net worth)

Collateral (pledged assets)

Conditions (economic conditions)

Compliance (compliance with laws and regulations, such as the Community Reinvestment Act, the Environmental Superfund Act, lender liability, etc.).

• Structuring commercial loan agreements– Terms of the loan agreement:

Type of credit facility (e.g., term loan) and amount to be borrowed.

Term of loan/method of repayment/ interest rates and fees/collateral

Covenants (promises by the borrower to take or not take certain actions during the term of the loan)

The lending process• Pricing commercial loans

– How to calculate the effective yield:The nominal interest rate is the stated rate in the loan agreement. The

effective yield takes into account the payment accrual basis and the payment frequency.

Payment accrual basis refers to the number of days used in the interest rate calculation. For example, 365-day year and 360-day year calculations ($1 million at 10% has a daily payment of $273.97 using 365 days versus $277.78 using 360 days).

Number of days outstanding can be actual number of days or a 30-day month base.

Frequency of interest payments can be monthly, quarterly, or annual.

A n E x a m p l e : C a l c u l a t i n g E f f e c t i v e Y i e l d

T o i l l u s t r a t e t h e e f f e c t i v e y i e l d , l e t ' s c o n s i d e r a 3 4 5 - d a y t e r m l o a n b e g i n n i n g o n J a n u a r y 1 a n d e n d i n g o n D e c e m b e r 1 1 . T h e

p r i n c i p a l a m o u n t i s $ 1 m i l l i o n a n d t h e i n t e r e s t r a t e i s 1 0 % . T h e c a l c u l a t i o n s f o r a 3 6 0 - d a y y e a r a n d 3 0 - d a y m o n t h a r e a s f o l l o w s :

1 . $ 1 , 0 0 0 , 0 0 0 P r i n c i p a l a m o u n t2 . x 0 . 1 0 A n n u a l i n t e r e s t r a t e3 . $ 1 0 0 , 0 0 0 A n n u a l i n t e r e s t a m o u n t4 . 3 6 0 D i v i d e b y n u m b e r o f d a y s i n y e a r ( 3 6 0 o r

3 6 5 )5 . $ 2 7 7 . 7 8 D a i l y i n t e r e s t p a y m e n t6 . x ( 3 0 d a y s x 1 1 m o n t h s + 1 1 d a y s ) T i m e s e l e v e n 3 0 - d a y m o n t h s p l u s 1 1 d a y s ( 3 4 1 d a y s ) o r t h e a c t u a l n u m b e r o f d a y s7 . $ 9 4 , 7 2 2 . 2 2 T o t a l i n t e r e s t p a i d

%02.10345

365

.00$1,000,000

$94,722.22

daysin loan of Term

365

amount Principal

paidinteres t Total = Effective

x

x

T h e s a m e p r o c e s s ( w i t h t h e a p p r o p r i a t e n u m b e r o f d a y s i n l i n e s 4 a n d 6 ) m a y b e u s e d t o c a l c u l a t e t h e e f f e c t i v e y i e l d s f o r 3 6 0 - d a y

y e a r s w i t h a c t u a l n u m b e r o f d a y s a n d 3 6 5 - d a y y e a r w i t h a c t u a l n u m b e r o f d a y s . T h e e f f e c t i v e y i e l d f o r t h e t h r e e m e t h o d s a r e a s

f o l l o w s :E f f e c t i v e Y i e l d

3 6 0 - d a y y e a r / 3 0 - d a y m o n t h 1 0 . 0 2 %3 6 0 - d a y y e a r / a c t u a l n u m b e r o f d a y s 1 0 . 1 4 %3 6 5 - d a y y e a r / a c t u a l n u m b e r o f d a y s 1 0 . 0 0 %

Effect of Payment Frequency on Interest Earned and Yields. The frequency of loanpayments has a major impact on interest earned and the yield received on loans. Suppose that a bank isconsidering making a one-year, $100,000 loan at 12% interest. The $100,000 loan will be repaid at the endof the year. The bank earns $12,000.00 if interest is paid annually, and $12,747.46 if it is paid daily. Thebank earns more when interest is collected frequently.

Payment Periods Interest earned on $100,000 loan Yield Continuous $12,748.28 12.748%Daily $12,747.46 12.747%Monthly $12,682.50 12.683%Quarterly $12,550.88 12.551%Annually $12,000.00 12.000%

The amount that the bank receives at the end of the period may be determined by the equation for the futurevalue of $1:

FVn = PVo(1 + i/m)nm FVn = future value at end of n periods

PVo = present value ($100,000 in this example)

i = interest raten = number of periodsm = number of interyear periods (days, months, quarters).

Thus, the amount earned if interest is collected monthly is:

FV12 = $100,000(1 + 0.12/12)1x12 = $112,682.50

Interest earned is the difference between FV12 and PVo, which is:

$112,682.50 - $100,000 = $12,682.50

It follows that the annual yield is:1

= 12.683%Many loans are amortized, which means that the principal is reduced with periodic payments. Methods for computing the annualinterest rates (APR) on such loans are explained in connection with consumer loans in Chapter 8.

1The continuous yield is determined by calculating ein = (2.718)0.12x1 = 12.7483%, where e = Euler's constant and where ein is

the limit of (1 + i/m)nm.

1The continuous yield is determined by calculating ein = (2.718)0.12x1 = 12.7483%, where e = Euler's constant and where ein is

the limit of (1 + i/m)nm.

The lending process• Loan pricing

– Markups:Index rate (i.e., prime rate) plus a markup of one or more percentage points.

Cost of funds (i.e., 90-day CD rate) plus a markup.

These methods are simple but may not properly account for loan risk, cost of funds, and operating expenses.

– Loan pricing models:Return on net funds employed:

Marginal cost of capital (funds) + Profit goal = (Loan income - Loan expense)/Net bank funds employed

Here the required rate of return is marginal cost of capital (funds) + Profit goal. We assume that marginal cost of capital equals the weighted average cost of capital (WACC) equals 6%.

The profit goal considers the risk of each loan to determine the markup. Assume this equals 2%.

Loan expense includes all direct and indirect costs of the loan but not the bank’s interest cost of funds. Assume $2,000 for labor, etc.

Net bank funds employed is the average amount of the loan over its life, less funds provided by the borrower, net of Fed reserve requirements. Assume $100,000.

(6% + 2%) = (Loan income - $2,000)/$100,000

Loan income = $10,000. Must earn this amount to reach the required rate of return.

The lending process• Relationship pricing:

– Must consider all investment cash flows in the loan pricing decision.

• Minimum spread:– Compare the lending rate to the cost of funds plus a profit margin.

• Average cost versus marginal cost:– When market interest rates are changing, average cost could clearly be

incorrect.

– If a loan was match funded by issuing CDs, the marginal cost is clearly more appropriate.

• Performance pricing:– Change the loan rate if the firm’s riskiness changes.

• Monitoring and loan review:– Compliance with loan agreement.