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