Bank Management, 6th edition.
Timothy W. Koch and S. Scott MacDonald
Copyright © 2005 by South-Western, a division of Thomson Learning
THE EFFECTIVE USE
OF CAPITAL
Chapter 9
Why worry about bank capital?
…capital reduces the risk of failure by acting as a
cushion against losses and by providing access to
financial markets to meet liquidity needs.
 While bank capital-to-asset ratios averaged near 20% at the turn
of the century, comparable ratios today are closer to 8 percent.
15.00%
Historical Trends in Bank Capital
13.00%
11.00%
9.00%
7.00%
5.00%
3.00%
1.00%
-1.00%
Total Capital to Total Assets
Growth Rate in Total Capital
Equity-to-Asset Ratios
20
15
Colonial Bank, AL
Peoples First, FL
Orion Bank, FL
Percent
10
Bankunited, FL
Silverton Bank, GA
Irwin Union, KY
5
North Houston, TX
Madisonville State, TX
Citizens Nat., TX
20
07
Q
20
1
07
Q
20
2
07
Q
20
3
07
Q
20
4
08
Q
20
1
08
Q
2
20
08
Q
20
3
08
Q
20
4
09
Q
20
1
09
Q
20
2
09
Q
20
3
09
Q
4
0
-5
Franklin Bank, TX
Risk-based capital standards
 During the last half of the 1980s, for
example, all U.S. banks were required
to meet a 5.5% minimum primary
capital requirement and a 6 percent
minimum total capital requirement.
 Primary capital consisted of
stockholders equity, perpetual
preferred stock, mandatory convertible
debt, and loan loss reserves.
The Basle agreement
 In 1986, U.S. bank regulators proposed
that U.S. banks be required to maintain
capital that reflects the riskiness of
bank assets.
 By 1988, the proposal had grown to
include risk-based capital standards
for banks in 12 industrialized nations
according to the terms of the Basle
Agreement.
 Regulations were fully in place by the
Terms of the Basle Agreement varied,
primarily in terms of what constitutes capital,
but there are common elements.
 Minimum capital requirement is linked to its
credit risk as determined by the
composition of assets.
 Stockholders' equity is deemed to be the
most critical type of capital.
 Minimum capital requirement increased to
8% for total capital.
 Capital requirements were approximately
Risk-based elements of the plan
 To determine minimum capital
requirements, bank managers follow a
four-step process:
1.
Classify assets into one of four risk
categories;
2.
Classify off-balance sheet commitments
and guarantees into the appropriate risk
categories;
3.
Multiply the dollar amount of assets in each
risk category by the appropriate risk
weight; this equals risk-weighted assets;
and
Regional National Bank (RNB), risk-based
capital
Regional National Bank (RNB)
Assets
$ 1,000
Category 1: Zero Percent
Cash & reserve
Trading Account
U.S. Treasury & agency secs.
Federal Reserve stock
Total category 1
Category 2: 20 percent
Due form banks / in process
Int. bearing Dep./F.F.S.
Domestic dep. institutions
Repurchase agrements (U.S. Treas & agency)
U.S. Agencies (gov. sponsored)
State & Muni's secured tax auth
C.M.O. backed by agency secs.
SBAs (govt. guaranteed portion)
Other category 2 assets
Total category 2
Category 3: 50 percent
C.M.O. backed by mtge loans
State & Muni's / all other
Real estate: 1-4 family
Other category 3 assets
Total category 3
Risk
Weight
Risk
Weighted
Assets
104,525
830
45,882
5,916
157,153
0.00%
0.00%
0.00%
0.00%
0
0
0
0
0
303,610
497,623
38,171
329,309
412,100
87,515
90,020
29,266
0
1,787,614
20.00%
20.00%
20.00%
20.00%
20.00%
20.00%
20.00%
20.00%
20.00%
60,722
99,525
7,634
65,862
82,420
17,503
18,004
5,853
0
357,523
10,000
68,514
324,422
0
402,936
50.00%
50.00%
50.00%
50.00%
5,000
34,257
162,211
0
201,468
Regional National Bank (RNB)
Risk-based capital
Regional National Bank (RNB), Risk-Based Capital
Assets
$ 1,000
Category 4: 100 percent
Loans: comm/ag/inst/leases
Real estate, all other
Allowance for loan and lease losses
Other investments
Premises, eq. other assets
Other category 4 assets
Total category 4
Total Assets before Off-Balance Sheet
Off-Balance Sheet Contingencies
0% collateral category
20% collateral category
50% collateral category
100% collateral category
Total Contingencies
Total Assets and Contingencies before
allowance for
Less: Excess allowance for loan and lease losses
(amount that exceeds 1.25% of gross RAA)
Total Assets and Contingencies
1,966,276
388,456
(70,505)
168,519
194,400
0
2,647,146
Risk
Weight
100.00%
100.00%
0.00%
100.00%
100.00%
100.00%
4,994,849
0
0
364,920
290,905
655,825
5,650,674
Risk
Weighted
1,966,276
388,456
0
168,519
194,400
0
2,717,651
3,276,642
0.00%
20.00%
50.00%
100.00%
0
0
182,460
290,905
473,365
3,750,007
(2,152)
5,650,674
3,747,855
Regional National Bank (RNB)
Risk-based capital (continued)
Regional National Bank (RNB)
Off Balance Sheet Conversions
Contingencies 100% conversion factor
Direct Credit substitues
Acquisition of participations in BA, direct
Assets sold w/ recourse
Futures & forward contracts
Interest rate swaps
Other 100% collateral category
Total 100% collateral category
Contingencies 50% conversion factor
Transaction-related contingencies
Unused commitments > 1 year
Revolving underwriting facilities (RUFs)
Other 50% collateral category
Total 50% collateral category
Contingencies 20% conversion factor
Short-term trade-related contingencies
Other 20% collateral category
Total 20% collateral category
Contingencies 0% conversion factor
Loan commitments < 1 year
Other 0% collateral category
Total 0% collateral category
1999
Assets
$ 1,000
$ Amt.
Risk
Weight
Risk
Weighted
Assets
Credit
Credit
165,905
0
0
50,000
75,000
0
290,905
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
165,905
0
0
50,000
75,000
0
290,905
0
364,920
0
0
364,920
50.00%
50.00%
50.00%
50.00%
0
182,460
0
0
182,460
0
0
0
20.00%
20.00%
0
0
0
0
0
0
0.00%
100.00%
0
0
0
General descriptions of the four risk categories
Asset
Category
1
2
Risk
Weight
0%
20%
Effective
Total Capital
Requirement
Obligor, Collateral, or Guarantor of the Asset
0%
Direct obligations of the federal government:
currency and coin, government securities, and
unconditional government guaranteed claims.
Also balances due or guaranteed by depository
institutions.
1.6%
Indirect obligations of the federal government:
most federal agency securities, full faith and credit
municipal securities, and domestic depository
institutions.
Assets collaterlized by federal
government obligations are generally included in
this category: repurchase agreements (when
Treasuries serve as collateral) and CMOs backed
by government agency securities.
3
50%
4%
Loans secured by one to four family properties
and municipal bonds secured by revenues of a
specific project (revenue bonds).
4
100%
8%
All other claims on private borrowers.
What constitutes bank capital?
…according to accounting definition, capital or net
worth equals the cumulative value of assets minus the
cumulative value of liabilities, and represents ownership
interest in a firm.
 Total equity capital equals the sum of:
 common stock,
 surplus,
 undivided profits and capital reserves, and
 net unrealized holding gains (losses) on
available-for-sale securities and cumulative
foreign currency translation adjustments,
and
 perpetual preferred stock
Risk-based capital standards
…two measures of qualifying bank capital
1. Tier 1 or core capital consists of (4%
required):

common equity,

qualifying perpetual preferred stock, and

minority interest in consolidated
subsidiaries, less intangible assets such as
goodwill.
2. Tier 2 capital or supplementary capital (4%
req.):

allowance for loan loss reserves up to 1.25
percent of risk-weighted assets,
Leverage capital ratios
 Regulators are also concerned that a bank
could acquire so many low-risk assets that
risk-based capital requirements would be
negligible
 hence, regulators have also imposed a 3
percent leverage capital ratio, defined as:

Tier 1 capital divided by total assets net of goodwill and
disallowed intangible assets and deferred tax assets.
 This capital requirement was implemented
to prevent banks from operating with little
or no capital, even though risk-based
standards might allow it.
Risk-based capital ratios for different-sized U.S.
Commercial banks
Asset Size
Number of Institutions Reporting
Equity capital ratio (%)
Return on equity (%)
Core capital (leverage) ratio (%)
Tier 1 risk-based capital ratio (%)
Total risk-based capital ratio (%)
Year
2001
2000
1999
1997
1995
2001
2000
1999
1997
1995
2001
2001
2001
2001
$100
Million
to $1
< $100
Million Billion
4,486
3,194
4,842
3,078
5,156
3,030
5,853
2,922
6,658
2,861
10.9
9.68
11.08
9.6
10.68
9.24
10.81
9.62
10.42
9.39
8.07
12.24
10.63
9.17
15.87
12.88
16.96
14.06
$1 to
$10
Billion
320
313
318
301
346
9.76
8.99
9.09
9.16
8.57
13.77
8.74
11.83
13.77
> $10
Billion
80
82
76
66
75
8.77
8.05
7.87
7.58
7.19
13.43
7.23
8.86
12.16
All
Commercial
Banks
8,080
8,315
8,580
9,142
9,940
9.09
8.49
8.37
8.33
8.11
13.1
7.79
9.9
12.72
FDICIA and bank capital standards
 Effective December 1991, Congress passed the
Federal Deposit Insurance Improvement Act
(FDICIA) with the intent of revising bank capital
requirements to:

emphasize the importance of capital and

authorize early regulatory intervention in problem
institutions, and

authorized regulators to measure interest rate risk at
banks and require additional capital when it is deemed
excessive.
 A focal point of the Act was the system of prompt
corrective action, which divides banks into
categories or zones according to their capital
positions and mandates action when capital
minimums are not met.
Five capital categories of FDICIA.
 Not subject to regulatory directives
regarding capital:
1.
2.
well-capitalized and
adequately capitalized banks
 Subject to regulatory restrictions:
3.
4.
5.
Undercapitalized,
significantly undercapitalized and
critically undercapitalized
Capital categories under FDICA
Total RiskBased Ratio
Well capitalized
10%
&
6%
Adequately capitalized
8%
&
4%
Undercapitalized
< 8%
or
< 4%
Tier 1 Capital Directive / Requirement
Leverage
Ratio
Not subject to a capital
directive to meet a specific level
&
5%
for any capital measure
Does not meet the definition of
&
4%
well capitalized
or
< 4%
Significantly undercapitalized
< 6%
or
< 3%
or
Critically undercapitalized
Tier 1 RiskBased Ratio
< 3%
Ratio of tangible equity to total assets is  2%
Prompt regulatory action under FDICIA
B.
Provisions for Prompt Corrective Action
Category
Well capitalized
Adequately capitalized
Undercapitalized
Significantly
undercapitalized
Critically undercapitalized
Mandatory Provisions
Discretionary Provisions
None
None
1. No brokered deposits, except with
FDIC approval
1. Suspend dividends and management
fees
2 Require capital restoration plan
3. Restrict asset growth
4. Approval required for acquisitions,
branching, and new activities
5. No brokered deposits
1. Same as for Category 3
2. Order recapitalization
3. Restrict interaffiliate transaction
4. Restrict deposit interest rates
5. Pay of officers restricted
None
1. Same as for Category 4
2. Receiver/conservator
within 90
daysd
3. Receiver if still in Category 5 four
quarters after becoming critically
undercapitalized
4. Suspend
payments on subordinated
debtd
5. Restrict certain other activities
Order recapitalization
2. Restrict interaffiliate transactions
3. Restrict deposit interest rates
4. Restrict certain other activities
5. Any other action that would better
carry out prompt corrective action
1. Any Zone 3 discretionary actions
2. Conservatorship or receivership if
fails to submit or implement plan or
recapitalize pursuant to order
3. Any other Zone 5 provision, if such
action is necessary to carry out
prompt corrective action
Tier 3 capital requirements for market risk
…many large banks have dramatically increased the size and
activity of their trading accounts, resulting in greater exposure to
market risk.
 Market risk is the risk of loss to the bank from
fluctuations in interest rates, equity prices, foreign
exchange rates, commodity prices, and exposure to
specific risk associated with debt and equity
positions in the bank’s trading portfolio.

Market risk exposure is, therefore, a function of the
volatility of these rates and prices and the corresponding
sensitivity of the bank’s trading assets and liabilities.
Tier 3 capital requirements for market risk
… risk-based capital requires banks with significant market risk to
measure their market risk exposure and hold sufficient capital to
mitigate
this exposure.
 A bank
is subject to market risk capital guidelines
…if consolidated trading activity (the sum of trading assets
and liabilities for the previous quarter) equals 10 percent or
more of the bank’s total assets for the previous quarter, or $1
billion or more in total dollar value.
 Banks subject to market risk capital guidelines
must maintain an overall minimum 8 percent ratio
of total qualifying capital to risk-weighted assets
and market risk equivalent assets.
 Tier 3 capital allocated for market risk plus Tier 2
capital allocated for market risk are limited to 71.4
percent of a bank’s measure for market risk.
Value-at-risk
 Market risk exposure is a function of
the volatility of rates and prices and
the corresponding sensitivity of the
bank's trading assets and liabilities.
 The largest banks use a value-at-risk
(VAR) based capital charge, estimated
by using an internally generated risk
measurement model.
The original Basel Accord’s approach to capital
requirements was primarily based on credit risk.
 Although it set appropriate protections from a
market- and credit-risk perspective, it did not
address operational or other types of risk.
 Operational risk itself is not new to financial
institutions.
 It’s the first risk a bank must manage, even
before making its first loan or executing its first
trade.

By 2005, a bank’s regulatory capital needs could
increase significantly—up to 20 percent of total
risk-based capital—as a result of its exposure to
operational risk.
The new BASEL capital accord (BASEL II)
and operational risk
 September 11, 2001 tragically demonstrated the
need for banks to protect themselves against
operational risk to their systems and people.
 Starting in 2005, regulators will calculate capital
according to the recently adopted Basel II Accord.
 The new focus of Basel II is operational risk.
 The focus is on the optimum use of capital in the
technology and business process operations
areas.
 The Basel Committee defines operational risk as
“the risk of loss resulting from inadequate or failed
internal processes, people, and systems, or from
external events.”
Functions of bank capital
 Provides a cushion for firms to absorb
losses and remain solvent.
 Provides ready access to financial markets,
guards against liquidity problems.
 Constrains growth and limits risk-taking:
TA / TA = EQ / EQ
ROA  (1  DR)  EC / TA
TA / TA 
EQ / TA  ROA  (1  DR)
Example:
TA / TA = EQ / EQ
 Assume ROA=1.1%, 7% equity, DR=40%:
0.011 (1  0.4)  0
TA/TA 
0.07  0.011 (1  0.4)
 .1041 or 10.41%
Weakness of risk-based capital standards
 Current standards only account for credit and
market risk at large banks with extensive trading
operations.

The new Basel II also accounts for operational risk.
 Book value of capital is not the most meaningful
measure of soundness.

Ignores changes in market values, unrealized gains or
losses on held-to-maturity investments, bank charter
value, and FDIC insurance.

Trading account securities must be marked-to-market and
unrealized gains and losses reported on the income
statement, but other bank assets and liabilities are
generally listed at book value
 Loan Loss Allowance, is anticipated default losses but
does not generally take into account the change in
value of the loans from changes in interest rates.
Application of Equation 13.2
Case 1: 8% asset growth, dividend payout = 40%, and capital ratio = 8%.
What is ROA?
ROA(1  0.40)  0
0.08 
0.08  ROA(1  0.40)
Solve for ROA  0.99%
Case 2: 12% asset growth, dividend payout = 40%, and capital ratio = 8%.
What is required ROA to support the 12% asset growth?
ROA(1  0.40)  0
0.12 
0.08  ROA(1  0.40)
Solve for ROA  1.43%
Case 3: ROA = 0.99%, 12% asset growth, and capital ratio = 8%.
What is the required  dividend payout to support the 12% asset growth?
0.0099(1  DR)  0
0.12 
0.08  0.0099(1  DR)
Solve for DR  13.42%
Case 4: ROA = 0.99%, 12% asset growth, capital ratio = 8%, and dividend payout = 40%.
What is the required  external capital to support the 12% asset growth?
0.0099(1  0.40)  ΔEC/TA
0.12 
0.08  0.0099(1  0.40)
Solve for EC/TA  0.29%
ΔEC  $294,720
The effect of capital requirements on bank
operating policies:
limiting growth
Case 1
Ratio
Asset growth rate (percent)
Asset size (millions of $)
ROA (percent)
Dividend payout rate (percent)
Undiv. Profits (millions of $)
Total capital less undiv. Profits ($millions)
Total capital / total assets (percent)
Intitial Initial 8%
Position Asset
Growth
8.00%
100.00
108.00
0.99%
40.00%
4.00
4.64
4.00
4.00
8.00%
8.00%
Case 2 Case 3
12%
Growth:
 ROA
12.00%
112.00
1.43%
40.00%
4.96
4.00
8.00%
Case 4
12% 12% Growth:
Growth:  External
 ROA
Capital
12.00%
12.00%
112.00
112.00
0.99%
0.99%
13.42%
40.00%
4.96
4.665
4.00
4.295
8.00%
8.00%
External capital sources



Banks that choose to expand more rapidly must
obtain additional capital from external sources, a
capability determined by asset size.
Large banks tap the capital markets regularly, but
small banks must pay a premium to obtain capital,
if it is available at all.
Capital sources can be grouped into one of four
categories:
1.
2.
3.
4.

subordinated debt,
common stock,
preferred stock, or trust preferred stock and
leases.
Each carries advantages and disadvantages.
Subordinated debt
 Does not qualify as Tier 1 or core capital
 Imposes an interest expense burden on the bank
when earnings are low.
 Subordinated debt offers several advantages to
banks.


interest payments are tax-deductible,
generates additional profits for shareholders as long as
earnings before interest and taxes exceed interest
payments.
 Subordinated debt also has shortcomings.


interest and principal payments are mandatory, default if
not paid
many issues require sinking funds
Common stock
 Common stock is preferred by regulators as a
source of external capital.

It has no fixed maturity and thus represents a permanent
source of funds.

Dividend payments are discretionary,

Losses can be charged against equity, not debt, so
common stock better protects the FDIC.
 Common stock is not as attractive from the bank's
perspective due to its high cost because:

dividends are not tax-deductible,

transactions costs on new issues exceed costs on debt,
and shareholders are sensitive to earnings dilution and
possible loss of control in ownership.
Preferred stock
 Preferred stock is a form of equity in which
investors' claims are senior to those of common
stockholders.
 As with common stock, preferred stock pays
nondeductible dividends

One significant difference is that corporate
investors in preferred stock pay taxes on only 20
percent of dividends.

For this reason, institutional investors dominate the
market.
 Most issues take the form of adjustable-rate
perpetual stock.
Trust preferred stock
 Trust preferred stock is a hybrid form of equity
capital at banks.
 It is attractive because it effectively pays dividends
that are tax deductible.
 To issue the security, a bank establishes a trust
company.

The trust company sells preferred stock to investors and
loans the proceeds of the issue to the bank.

Interest on the loan equals dividends paid on preferred
stock.

The loan is tax deductible such that the bank deducts
dividend payments.

As a bonus, the preferred stock counts as Tier 1 capital!!
Capital planning
 Capital planning is part of the overall asset and
liability management process.
 Bank management makes decisions regarding the
amount of risk assumed in operations and potential
returns.
 The amount and type of capital required is
determined simultaneously with the expected
composition of assets and liabilities and forecasts
of income and expenses.
 The greater assumed risk and asset growth, the
greater is required capital.
Capital planning: forecast performance measures for a bank with
deficient capital ratios
2001
2002
2003
2004
Historical 10% Growth in Assets: $250,000 In Dividends
Total assets
$ 80.00
$ 88.00
$ 96.80
$
Net interest margin
4.40%
4.40%
4.50%
ROA
0.45%
0.45%
0.60%
Total capital
$ 5.60
$ 5.75
$ 6.08
Capital ratio
7.00%
6.53%
6.28%
106.48
4.60%
0.65%
$ 6.52
6.12%
2005
$ 117.13
4.70%
0.75%
$ 7.15
6.10%
Shrink the Bank, reduce assets by $1 million a year: $250,000 In Dividends
Total assets
$ 80.00
$ 79.00
$ 78.00
$ 77.00
$ 76.00
Net interest margin
4.40%
4.40%
4.50%
4.60%
4.70%
ROA
0.45%
0.45%
0.60%
0.65%
0.75%
Total capital
$ 5.60
$ 5.71
$ 5.92
$ 6.17
$ 6.49
Capital ratio
7.00%
7.22%
7.59%
8.02%
8.54%
Slow Growth, $2 million increase in assets each year: No Dividends
Total assets
$ 80.00
$ 82.00
$ 84.00
$ 86.00
$ 88.00
Net interest margin
4.40%
4.40%
4.50%
4.60%
4.70%
ROA
0.45%
0.45%
0.60%
0.65%
0.75%
Total capital
$ 5.60
$ 5.97
$ 6.47
$ 7.03
$ 7.69
Capital ratio
7.00%
7.28%
7.71%
8.18%
8.74%
Slow Growth, $2 million increase in assets each year:
$250,000 In Dividends, $800,000 External Capital Injection In 2004
Total assets
$ 80.00
$ 82.00
$ 84.00
$ 86.00
$ 88.00
Net interest margin
4.40%
4.40%
4.50%
4.60%
4.70%
ROA
0.45%
0.45%
0.60%
0.65%
0.75%
Total capital
$ 5.60
$ 5.72
$ 5.97
$ 7.08
$ 7.49
Capital ratio
7.00%
6.97%
7.11%
8.23%
8.51%
Federal deposit insurance
 The Banking Act of 1933 established the FDIC and
authorized federal insurance for bank deposits up
to $2,500. Today coverage stands at $100,000 per
account.
 The initial objectives of deposit insurance were to
prevent liquidity crises caused by large-scale
deposit withdrawals and bank failure.
 The large number of failures in the late 1980s and
early 1990s put pressure on the FDIC by slowly
depleting the reserve fund.
By the late 1990’s, the FDIC was well
funded

The Financial Institution Reform, Recovery, and
Enforcement Act of 1989 (FIRREA) authorized the
issuance of bonds to finance the bailout of the
FSLIC and provide resources to close problem
thrifts.

The Deposit Insurance Funds Act of 1996 (DIFA)
was enacted on September 30, 1996
1.
2.
3.
Included both a one-time assessment on SAIF deposits
to capitalize the SAIF fund
Required the repayment of the Financing Corporation
(FICO) bonds
Mandated the ultimate elimination of the BIF and SAIF
funds by merging them into a new Deposit Insurance
Fund
Risk-based deposit insurance
 FDIC insurance premiums are assessed based on a
Risk-Based Deposit Insurance system required by
the FDIC Improvement Act of 1991 and adopted in
September 1992.
 These premiums are reviewed semiannually by the
FDIC to ensure that:


premiums appropriately reflect the risks posed to the
insurance funds and
that fund reserve ratios are maintained at or above the
target Designated Reserve Ratio (DRR) of 1.25 percent of
insured deposits
 Deposit insurance premiums are assessed as basis
points per one hundred dollars of insured deposits.
FDIC reserve ratios, fund balance, and
insured deposits
Insurance Fund Balance as a Percent of Total Insured Deposits
1.75%
BIF
SAIF
1.50%
1.25%
Target Ratio
1.00%
0.75%
0.50%
0.25%
0.00%
1991
-0.25%
-0.50%
1992
1993
1994
1995
1996
Year
1997
1998
1999
2000
2001
At the beginning of 2002, over 93% of banks
are listed in the lowest category and pay no
FDIC insurance premiums.
Capital Group
Well capitalized
Adequately capitalized
Undercapitalized
Supervisory Subgroups
A
B
C
0 bp
3 bp
17 bp
3 bp
10 bp
24 bp
10 bp
24 bp
27 bp
Problems with deposit insurance
 Government backed deposit
insurance provides for stability of
the financial system by reducing or
preventing banking panics and
protecting the less sophisticated
depositor — but this comes at a
price.
Problems with deposit insurance
…First, deposit insurance acts similarly to bank capital
and is a substitute for some functions of bank capital.
 Investors or depositors look to the company’s capital as
a safety net in the event of failure.
 Lower capital levels mean firms must pay a risk
premium to attract funds or they will find it difficult to
borrow money.
 A large portion of funds come from insured
depositors who do not depend on the bank’s capital
position


A large number of depositors, therefore, do not require
a risk premium to be paid by the bank.
Normal market discipline which requires the bank to
pay a risk premium does not apply to all providers of
funds.
 Some large banks are considered to be “too-big-to-fail”.

Creditors of a large bank would receive de facto
100% insurance regardless of the size or type of
liability.
Problems with deposit insurance
…Second, deposit insurance has historically ignored the
riskiness of bank operations, which represents the
critical factor that leads to failure.
 Two banks with equal amounts of domestic deposits paid
the same insurance premium, even though one invested
heavily in risky loans and the other owned only U.S.
government securities and just 50 percent of its deposits
were fully insured.
 This creates a moral hazard problem whereby bank
managers had an incentive to increase risk.
 For example, suppose that a bank had a large portfolio
of problem assets that was generating little revenue.

Managers could use deposit insurance to access funds
via brokered CDs in $100,000 blocks.
Problems with deposit insurance
… Third, deposit insurance funds were always viewed as providing
basic insurance coverage.
 Historically, there were three fundamental problems with
deposit insurance pricing.

Premiums were not sufficient to cover potential payouts.
 The FDIC and FSLIC were expected to establish reserves of 5
percent of covered deposits funded by premiums.
 Reserves never exceeded 2% of insured deposits as Congress
kept increasing coverage while premiums were constant.

Deposit insurance coverage slowly increased from
$15,000 per account per institution in 1966 to $20,000
in 1969, $40,000 in 1974, and $100,000 in 1980.


Customers could obtain multiple account coverage at a single
institution by carefully structuring ownership of each account.
High failure rates during the 1980s and the insurance
funds demonstrate that premiums were inadequate.
Problems with deposit insurance
… The final historical problem with deposit insurance is
that premiums were not assessed against all of a bank’s
insured liabilities.
 Many liabilities that the federal government
effectively guaranteed should have required
insurance premiums.

For example, insured deposits consisted only of
domestic deposits while foreign deposits were
exempt.


The argument was that U.S. banks would be less
competitive with foreign bank competitors.
Too-big-to-fail doctrine means that large banks
would have coverage on 100% of their deposits
but pay as if they only had $100,000 coverage as
smaller banks do.
Bank Management, 6th edition.
Timothy W. Koch and S. Scott MacDonald
Copyright © 2006 by South-Western, a division of Thomson Learning
Overview of Credit Policy and
Loan Characteristics
Chapter 10
Recent Trends in Loan Growth Quality
 Larger banks have, on average,
recently reduced their dependence on
loans relative to smaller banks.
 Real estate loans represent the largest
single loan category for banks.
 Residential 1-4 family homes
contribute the largest amount of real
estate loans for banks.
 Commercial
real estate is highest for
banks with $100 million to $1 billion in
assets
Recent Trends in Loan Growth Quality
 Commercial and industrial loans
represent the second highest
concentration of loans at banks
 Loans to individuals are greatest for
banks with more than $1 billion in
assets
 Farmland and farm loans make up a
significant portion of the smallest
banks’ loans
a Percentage of Total Assets,
December 2004
Number of institutions reporting
Net loans and leases
Plus: Loan Loss Allowance
Total loans & leases
Plus: Unearned income
Loans and leases, gross
All real estate loans
Real estate loans in domestic offices:
Construction and land development
Commercial real estate
Multifamily residential real estate
1-4 family residential
Farmland
Real estate loans in foreign offices:
Farm loans
Commercial and industrial loans
To non-U.S. addressees
Loans to individuals
Credit cards
Related Plans
Other loans to individuals
Total other loans and leases *
Loans to foreign governments & official institutions
Obligs of states & political subdivisions in the U.S.
Other loans
Lease financing receivables
Of non-U.S. addressees
Loans to depository institutions and acceptances
Memoranda:
Commercial real estate loans not secured by real estate
Loans secured by real estate to non-U.S. addressees
Restructured loans and leases, total
Total loans & leases in foreign offices
Commercial Banks with Asset Size
< $100
Million
85
All
Comm
Banks
7630
All
Savs
Instits
1345
63.58%
0.95%
64.53%
0.05%
64.58%
42.18%
42.08%
6.73%
15.86%
2.27%
16.58%
0.64%
0.10%
0.58%
11.69%
0.35%
7.51%
2.76%
0.28%
4.46%
2.63%
0.01%
0.44%
0.97%
1.05%
0.06%
0.17%
55.02%
0.85%
55.87%
0.03%
55.90%
26.65%
25.83%
2.23%
4.83%
0.75%
17.90%
0.12%
0.82%
0.21%
10.72%
1.92%
11.21%
5.39%
0.55%
5.27%
7.11%
0.12%
0.31%
2.44%
2.03%
0.51%
2.20%
57.43%
0.87%
58.30%
0.04%
58.34%
31.20%
30.57%
3.45%
7.93%
1.04%
17.62%
0.53%
0.63%
0.58%
10.80%
1.48%
9.97%
4.42%
0.47%
5.09%
5.79%
0.09%
0.34%
1.99%
1.69%
0.39%
1.68%
71.27%
0.50%
71.78%
0.01%
71.79%
62.56%
62.56%
2.77%
5.02%
4.79%
49.97%
0.02%
0.00%
0.01%
3.54%
0.00%
5.39%
1.63%
0.02%
3.75%
0.28%
0.00%
0.02%
0.10%
0.10%
0.00%
0.06%
0.21%
0.04%
0.02%
0.27%
0.57%
0.69%
0.00%
5.28%
0.48%
0.52%
0.01%
3.99%
0.04%
0.00%
0.10%
0.00%
$1 to
$10
Billion
360
> $10
Billion
3655
$100
to $1
billion
3530
60.81%
0.89%
61.70%
0.04%
61.74%
38.74%
38.74%
4.35%
11.93%
0.85%
16.35%
5.26%
0.00%
6.24%
9.81%
0.00%
6.10%
0.10%
0.09%
5.91%
0.85%
0.00%
0.35%
0.23%
0.25%
0.00%
0.02%
66.39%
0.93%
67.33%
0.06%
67.39%
48.51%
48.51%
7.94%
19.55%
1.76%
17.08%
2.17%
0.00%
1.89%
10.60%
0.05%
5.06%
0.57%
0.15%
4.34%
1.33%
0.00%
0.43%
0.45%
0.34%
0.00%
0.11%
0.12%
0.00%
0.05%
0.00%
0.18%
0.06%
0.05%
0.03%
Recent Trends in Loan Growth Quality
 Wholesale Bank
 Emphasizes
lending to businesses
 Retail Bank
 Emphasizes
lending to individuals
 Primary funding is from core deposits
Recent Trends in Loan Growth Quality
 FDIC Bank Categories
 Credit Card Banks
 International Banks
 Agricultural Banks
 Commercial Lenders
 Vast majority of FDIC-insured institutions fall
in this category
 Mortgage Lenders
 Consumer Lenders
 Other Specialized Banks (less than $1 billion)
 All Other Banks (less than $1 billion)
 All Other Banks (more than $1 billion)
Credit Risk Diversification and Lending
Concentrations by Asset Concentrations:
December 2004
All
Institutions
Number of institutions reporting
Loans outstanding (in billions)
All real estate loans
Construction and development
Commercial real estate
Multifamily residential real estate
Home equity loans
Other 1-4 family residential
Commercial and industrial loans
Loans to individuals
Credit card loans
Other loans to individuals
All other loans and leases (including farm)
Average return on equity
Average return on assets
Net charge-offs to loans
8,975
60.16%
5.50%
12.28%
2.76%
8.01%
30.00%
15.82%
15.19%
6.52%
8.67%
8.83%
13.28%
1.29%
0.56%
Credit Card International Agricultural Commercial
Banks
Banks
Banks
Lenders
34
6.73%
0.00%
0.03%
0.00%
5.98%
0.71%
2.38%
89.43%
83.04%
6.39%
1.43%
22.16%
4.01%
4.67%
5
25.16%
0.86%
2.37%
0.29%
4.46%
12.08%
21.71%
25.72%
10.88%
14.84%
27.42%
10.35%
0.76%
0.91%
1,730
4,424
54.27%
3.41%
13.88%
1.02%
1.02%
16.27%
13.99%
7.39%
0.34%
7.17%
24.23%
11.45%
1.23%
0.21%
66.54%
10.90%
22.98%
4.42%
7.31%
19.89%
20.31%
8.02%
0.83%
7.19%
5.13%
13.48%
1.30%
0.30%
Mortgage
Lenders
Asset Concentration Group Definitions (Groups are hierarchical and mutually exclusive):
Credit card lenders—Institutions whose credit card loans plus securitized receivables exceed 50 percent of total assets plus securitized receivables.
International banks—Banks with assets greater than $10 billion and more than 25 percent of total assets in foreign offices.
Agricultural banks—Banks whose agricultural production loans plus real estate loans secured by farmland exceed 25 percent of total loans and leases.
Commercial lenders—Institutions whose commercial and industrial loans, plus real estate construction and development loans, plus loans secured by
commercial real estate properties exceed 25 percent of total assets.
Mortgage lenders—Institutions whose residential mortgage loans, plus mortgage-backed securities, exceed 50 percent of total assets.
990
91.56%
2.33%
4.72%
4.28%
9.25%
70.90%
3.54%
4.12%
0.53%
3.58%
0.79%
11.61%
1.18%
0.12%
Credit Risk Diversification and Lending
Concentrations by Asset Concentrations:
December 2004
Consumer
Lenders
Number of institutions reporting
Loans outstanding (in billions)
All real estate loans
Construction and development
Commercial real estate
Multifamily residential real estate
Home equity loans
Other 1-4 family residential
Commercial and industrial loans
Loans to individuals
Credit card loans
Other loans to individuals
All other loans and leases (including farm)
Average return on equity
Average return on assets
Net charge-offs to loans
132
27.62%
0.84%
2.53%
0.36%
6.51%
17.13%
8.93%
61.88%
15.20%
46.56%
1.57%
16.81%
1.66%
1.57%
Other
Specialized
<$1 Billion
465
68.42%
5.26%
19.55%
2.26%
2.26%
36.84%
12.03%
14.29%
1.50%
12.78%
5.26%
10.03%
1.66%
0.59%
All Other
<$1 Billion
All Other >$1
Billion
1,120
75
69.28%
3.98%
16.79%
1.24%
3.23%
39.55%
10.45%
13.68%
0.75%
12.94%
6.59%
10.18%
1.10%
0.31%
58.92%
3.45%
9.03%
1.27%
11.49%
32.83%
18.08%
11.54%
2.08%
9.45%
11.47%
13.69%
1.35%
0.25%
Asset Concentration Group Definitions (Groups are hierarchical and mutually exclusive):
Consumer lenders—Institutions whose residential mortgage loans, plus credit card loans, plus other loans to individuals, exceed 50 percent of
total assets.
Other specialized <$1 billion—Institutions with assets less than $1 billion, whose loans and leases are less than 40 percent of total assets.
All other <$1 billion—Institutions with assets less than $1 billion that do not meet any of the definitions above; they have significant lending
activity with no identified asset concentrations.
All other >$1 billion—Institutions with assets greater than $1 billion that do not meet any of the definitions above; they have significant lending
activity with no identified asset concentrations.
Relative Importance of Loans, Investment Securities,
and Cash Assets at Commercial Banks, 1935–2004
Total Loans as a Percent of Total Assets
50%
40%
Investment Securities as a Percent of Total Assets
30%
20%
Cash as a Percent of Total Assets
10%
3
19 5
3
19 8
4
19 1
4
19 4
4
19 7
50
19
5
19 3
5
19 6
5
19 9
6
19 2
65
19
6
19 8
7
19 1
7
19 4
7
19 7
8
19 0
8
19 3
8
19 6
8
19 9
9
19 2
9
19 5
9
20 8
0
20 1
04
0%
19
Percent of Total Assets
60%
Noncurrent Loans as a Percentage of Total
Loans, all FDIC Insured Institution, 1984–2004
8.00%
Noncurrent Loans Total Real Estate
Noncurrent Loans Commercial and Industrial
7.00%
Noncurrent Loans Loans to Individuals
Noncurrent Loans All Other Loans
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
Net Charge-offs by Loan Type at U.S.
Commercial Banks, 1985–2004
3.50%
3.00%
2.50%
2.00%
1.50%
1.00%
0.50%
0.00%
Charge-Offs Total Real Estate
Charge-Offs Commercial and Industrial
Charge-Offs Loans to Individuals
Charge-Offs All Other Loans
Credit Card Loss Rate and Personal Bankruptcy
Filings, 1984–2004
450
Net Credit Card Charge-Off Rates, %
Net Charge-off Rate (%)
7%
400
Personal Bankruptcy Filings (Thousands)
6%
350
5%
300
4%
250
3%
200
2%
150
1%
100
0%
1984 1986 1988
50
1990 1992 1994
1996 1998 2000 2002
2004
Number of Bankruptcy Filings (Thousands)
8%
Trends in Competition for Loan Business
 In 1984, there were nearly 14,500
banks in the U.S.
 This
fell to fewer than 7,700 at the
beginning of 2004
This reduction in the number of banks
is a direct result of the relaxation of
branching restrictions and increased
competition
 Banks face tremendous competition
 This has forced consolidation as banks
attempt to lower costs and provide a
broader base of services

Trends in Competition for Loan Business
 Most firms can obtain loans from
many different sources
 Finance
companies
 Life insurance companies
 Commercial paper
 Junk bonds
 Reduced regulation, financial
innovation, increased consumer
awareness, and new technology have
made it easier to obtain loans from a
variety of sources
Trends in Competition for Loan Business
 Banks still have the required expertise and
experience to make them the preferred
lender for many types of loans
 Technology advances have meant that more
loans are becoming “standardized,” making
it easier for market participants to offer loans
in direct competition to banks
 Structured Note

Loan that is specifically designed to meet the
needs of one or a few companies but has
been packaged for resale
Trends in Competition for Loan Business
 Many types of loans can be
standardized, credit scored and
securitized:
 Mortgages
 Government-guaranteed
student loans
 Small business loans (sponsored by the
SBA)
 Credit cards
 Auto loans
Trends in Competition for Loan Business
 Not all loans can be standardized
 Farm loans
 Many small business loans
 Repayment schedules and collateral are
often customized so that they do not
conform to some standard
 Medium to large businesses will have
specialized needs as well
 This is the area of lending that is still
dominated by commercial banks and
the area in which the bank is uniquely
qualified
The Credit Process
Business Development and Credit
Analysis
 Market research
 Advertising, public relations
 Officer call programs
 Obtain formal loan request
 Obtain financial statements,
borrowing resolution, credit
reports
 Financial statement and cash
flow analysis
 Evaluate collateral
 Line officer makes
recommendation on
accepting/rejecting loan
Credit Execution and
Administration
 Loan committee reviews
proposal/recommendation
 Accept/reject decision made, terms
negotiated
 Loan agreement prepared with
collateral documentation
 Borrower signs agreement, turns
over collateral, receives loan
proceeds
 Perfect security interest
 File materials in credit file
 Process loan payments, obtain
periodic financial statements, call
on borrower
Credit Review
 Review loan documentation
 Monitor compliance with loan
agreement:
Positive and negative loan
covenants
Delinquencies in loan
payments
Discuss nature of delinquency or
other problems with borrower
 Institute corrective action:
Modify credit terms
Obtain additional capital,
collateral, guarantees
Call loan
The Credit Process
 Loan Policy- Formalizes lending guidelines
that employees follow to conduct bank
business

Credit Philosophy


Management’s philosophy that determines
how much risk the bank will take and in what
form
Credit Culture

The fundamental principles that drive lending
activity and how management analyzes risk
The Credit Process
 Credit Culture
 The
fundamental principles that drive
lending activity and how management
analyzes risk

Values Driven
 Focus is on credit quality

Current-Profit Driven
 Focus is on short-term earnings

Market-Share Driven
 Focus is on having the highest market
share
Business Development and Credit Analysis
 Business Development
 Market research
 Train employees:
 On what products are available
 What products customers are likely to
need
 How they should communicate with
customers about those needs
 Advertising and Public Relations
 Officer Call Programs
Business Development and Credit Analysis
 Credit Analysis
 Evaluate
a borrower’s ability and
willingness to repay
 Questions to address
What risks are inherent in the
operations of the business?
 What have managers done or failed to
do in mitigating those risks?
 How can a lender structure and control
its own risks in supplying funds?

Business Development and Credit Analysis
 Five C’s of Good Credit
 Character
 Capital
 Capacity
 Conditions
 Collateral
Business Development and Credit Analysis
 Five C’s of Bad Credit
 Complacency
 Carelessness
 Communication
 Contingencies
 Competition
Credit Execution and Administration
 Loan Decision



Individual officer decision
Committee
Centralized underwriting
 Loan Agreement






Formalizes the purpose of the loan
Terms of the loan
Repayment schedule
Collateral required
Any loan covenants
States what conditions bring about a default
Credit Execution and Administration
 Documentation: Perfecting the
Security Interest
 Perfected

When the bank's claim is superior to
that of other creditors and the borrower
 Require the borrower to sign a security
agreement that assigns the qualifying
collateral to the bank
 Bank obtains title to equipment or vehicles
Credit Execution and Administration
 Position Limits
 Maximum
allowable credit exposures
to any single borrower, industry, or
geographic local
 Risk Rating Loans
 Evaluating
characteristics of the
borrower and loan to assess the
likelihood of default and the amount of
loss in the event of default
Credit Execution and Administration
 Loan Covenants
 Positive

(Affirmative)
Indicate specific provisions to which
the borrower must adhere
 Negative

Indicate financial limitations and
prohibited events
Sample Loan Covenants
Negative
 Capital outlays cannot exceed $3
million annually
 Cash dividends cannot exceed 60%
of periodic earnings
 Total officers' salaries cannot exceed
$500,000 annually
 No liens on assets beyond existing
liens
 No mergers, consolidations, or
acquisitions without bank approval
 No sale, lease, or transfer of more
than 10% of existing assets
 No change in senior management
 No additional debt without bank
approval
Affirmative
 Borrower must maintain following financial
ratios:
Current ratio >1.0
Days receivables outstanding <50 days
Inventory turnover >4.5 times
Debt to total assets <70%
Net worth >$1 million
Fixed charge coverage >1.3 times
Cash flow from operations >dividends
+ current maturities of long-term debt
 Certified financial statements must be provided
within 60 days of end of each fiscal year
 Borrower will maintain $500,000 key man life
insurance policy on company president, with bank
named as beneficiary
 Bank will be allowed to inspect inventory,
receivables, and property periodically
 Borrower must pay all taxes and government fees,
unless contested in good faith, and comply with
all laws
 Borrower must inform bank of any litigation or
claim that might materially affect its performance
 Borrower must maintain all property in good
condition and repair
Credit Execution and Administration
 Loan Review
 Monitoring
the performance of existing
loans
 Handling problem loans
 Loan review should be kept separate
from credit analysis, execution, and
administration
 The
loan review committee should act
independent of loan officers and report
directly to the CEO of the bank
Credit Execution and Administration
 Problem Loans
 Often

require special treatment
Modify terms of the loan agreement to
increases the probability of full
repayment
 Modifications might include:
 Deferring interest and principal
payments
 Lengthening maturities
 Liquidating unnecessary assets
Characteristics of Different Types of Loans
 UBPR Classifications
 Real
Estate Loans
 Commercial Loans
 Individual Loans
 Agricultural Loans
 Other Loans and Leases in Domestic
Offices
 Other Loans and Leases in Foreign
Offices
Characteristics of Different Types of Loans
 Real Estate Loans
 Construction
and Development Loans
 Commercial Real Estate
 Multi-Family Residential Real Estate
 1-4 Family Residential
 Home Equity
 Farmland
 Other Real Estate Loans
Characteristics of Different Types of Loans
 Commercial Real Estate Loans
 Typically
short-term loans consisting
of:
Construction and Real Estate
Development Loans
 Land Development Loans
 Commercial Building Construction and
Land Development Loans

Characteristics of Different Types of Loans
 Commercial Real Estate Loans
 Construction Loans
 Interim financing on commercial,
industrial, and multi-family residential
property
 Interim Loans
 Provide financing for a limited time
until permanent financing is arranged
 Land Development Loans
 Finance the construction of road and
public utilities in areas where
developers plan to build houses
Characteristics of Different Types of Loans
 Commercial Real Estate Loans
 Developers
typically repay loans as
lots or homes are sold
 Takeout Commitment

An agreement whereby a different
lender agrees to provide long-term
financing after construction is finished
Characteristics of Different Types of Loans
 Residential Mortgage Loans
 Mortgage

Legal document through which a
borrower gives a lender a lien on real
property as collateral against a debt
 Most
are amortized with monthly
payments, including principal and
interest
Characteristics of Different Types of Loans
 Residential Mortgage Loans
 1-4 Family Residential Mortgage Loans
 Holding long-term fixed-rate mortgages
can create interest rate risk for banks
with loss potential if rates increase
 To avoid this, many mortgages now
provide for:
 Periodic adjustments in the interest rate
 Adjustments in periodic principal payments
 The lender sharing in any price appreciation
of the underlying asset at sale

All of these can increase cash flows to
the lender when interest rates rise
Characteristics of Different Types of Loans
 The Secondary Mortgage Market
 Involves
the trading of previously
originated residential mortgages

Can be sold directly to investors or
packaged into mortgage pools
 Home Equity Loans
 Second
Mortgage Loans
Typically shorter term than first
mortgages
 Subordinated to first mortgage

Characteristics of Different Types of Loans
 Equity Investments in Real Estate
 Historically,
commercial banks have
been prevented from owning real
estate except for their corporate
offices or property involved in
foreclosure
 Regulators want banks to engage in
speculative real estate activities only
through separate subsidiaries
Characteristics of Different Types of Loans
 Working Capital Requirements
 Net
Working Capital
Current assets – current liabilities
 For most firms, net working capital is
positive, indicating that some current
assets are not financed with current
liabilities

Characteristics of Different Types of Loans
 Working Capital Requirements
 Days Cash
 Cash/(Sales/365)
 Days Receivables
 AR/(Sales/365)
 Days Inventory
 Inventory/(COGS/365)
 Days Payable
 AP/(Purchases/365)
 Days Accruals
 Accruals/(Operating Expenses/365)
Characteristics of Different Types of Loans
 Working Capital Requirements
 Cash-to-Cash

How long the firm must finance
operating cash, inventory and accounts
receivables from the day of first sale
 Cash-to-Cash

Asset Cycle
Liability Cycle
How long a firm obtains interest-free
financing from suppliers in the form of
accounts payable and accrued
expenses to help finance the asset
cycle
Balance Sheet and Income Statement
Data for Simplex Corporation
Cash-to-Cash Cycle
Assets
Cash
Accounts receivable
Inventory
Current assets
Fixed assets
Total Assets
80
700
500
1,280
1,220
2,500
Liabilities and Equity
Accounts payable
400
Accrued expenses
80
Notes pay—bank
450
CM LTD
50
Current liabilities
980
LTD
550
Equity
970
Total Liabilities
2,500
and Equity
Selected Income Stat Data
Net sales
9,125
COGS
6,100
Operating expenses
2,550
Purchases*
6,430
Average Daily:
Sales
25.00
COGS
16.71
Operating expenses
6.99
Purchases
17.62
Working Capital Cycle †
Current Assets
Days cash
3.20
Days accounts receivable 28.00
Days inventory
29.92
Asset cycle
61.12
= 80 / 25.00
= 700 / 25.00
= 500 / 16.71
Current Liabilities
Days accounts payable 22.71
= 400 / 17.62
Days accruals
11.45
= 80 / 6.99
Liability cycle
Difference in cash-to-cash cycles = 26.96
Working Capital Needs = 26.96 x 16.71 = 450.58
34.16
Cash-to-Cash Working Capital Cycle for
Simplex Corporation
Days Cash = 3.20
Days Acct Rec = 28.00
Days Inventory = 29.92
Total = 61.12
Time
Days Payable = 22.71
Total = 34.16
Days Accruals = 11.45
Days Financing = 26.96
Working Capital Financing needs
= Deficit x Avg. Daily COGS
= 26.96 * 16.71
.
= 450.53
.
Characteristics of Different Types of Loans
 Seasonal versus Permanent Working
Capital Needs
 All
firms need some minimum level of
current assets and current liabilities
 The amount of current assets and
current liabilities will vary with
seasonal patterns
Characteristics of Different Types of Loans
 Permanent Working Capital
 The
minimum level of current assets
minus the minimum level of adjusted
current liabilities

Adjusted Current Liabilities
 Current liabilities net of short-term bank
credit and current maturities of long-term
debt
 Seasonal Working Capital
 Difference
in total current assets and
adjusted current liabilities
Trends in Working Capital Needs
Total Current Assets
Minimum Current Assets
Total Current Liabilities
Minimum Current Liabilities
Total = Permanent Working Capital Needs
+ Seasonal Working Capital Needs
Dollars
Seasonal Working Capital Needs
Permanent Working Capital Needs
q
Time
Short-Term Commercial Loans
 Open Credit Lines
 Loan
is seasonal if the need arises on
a regular basis and if the cycle
completes itself with one year
 Used to purchase raw materials and
build up inventories of finished goods
in anticipation of later sales
 It is self-liquidating in the sense that
repayment derives from the sale of
finished goods that are financed
Short-Term Commercial Loans
 Open Credit Lines
 The
bank makes a certain amount of
funds available to a borrower for a set
period of time

Often used for seasonal loans
 The
customer determines the timing of
the actual borrowings (“takedowns”)
 Borrowings increase with inventory
buildup and decline with the collection
of receivables
Short-Term Commercial Loans
 Open Credit Lines
 Typically
require that the loan be fully
repaid at least once during each year
to confirm that the needs are seasonal
 Commitment Fee

A fee, in addition to interest, for making
credit available
 May be based on the entire credit line or on
the unborrowed balance
Short-Term Commercial Loans
 Asset-Based Loans

Loans Secured by Inventories



The security consists of raw materials, goods
in process, and finished products.
The value of the inventory depends on the
marketability of each component if the
borrower goes out of business.
Banks will lend from 40 to 60 percent against
raw materials that are common among
businesses and finished goods that are
marketable, and nothing against unfinished
inventory
Short-Term Commercial Loans
 Asset-Based Loans
 Loans
Secured by Accounts
Receivable
The security consists of paper assets
that presumably represent sales
 The quality of the collateral depends on
the borrower’s integrity in reporting
actual sales and the credibility of
billings

Short-Term Commercial Loans
 Asset-Based Loans
 Loans Secured by Accounts
Receivable
 Accounts Receivable Aging Schedule
 List of A/Rs grouped according to the
month in which the invoice is dated

Lockbox
 Customer’s mail payments go directly to a
P.O. Box controlled by the bank
 The bank processes the payments and
reduces the borrower’s balance but
charges the borrower for handling the
items
Short-Term Commercial Loans
 Highly Levered Transactions
 Leveraged Buyout (LBO)
 Involves a group of investors, often part of the
management team, buying a target company
and taking it private with a minimum amount
of equity and a large amount of debt
 Target companies are generally those with
undervalued physical assets

The investors often sell specific assets or
subsidiaries to pay down much of the debt
quickly
 If key assets have been undervalued, the investors
may own a downsized company whose earnings
prospects have improved and whose stock has
increased in value
 The investors sell the company or take it public
once the market perceives its greater value.
Short-Term Commercial Loans
 Highly Levered Transactions
 Arise
from three types of transactions
LBOs in which debt is substituted for
privately held equity
 Leveraged recapitalizations in which
borrowers use loan proceeds to pay
large dividends to shareholders
 Leveraged acquisitions in which a cash
purchase of another related company
produces an increase in the buyer’s
debt structure

Term Commercial Loans
 Original maturity greater than 1 year

Typically finance:




Depreciable assets
Start-up costs for a new venture
Permanent increase in the level of working
capital
Lenders focus more on the borrower’s
periodic income and cash flow rather than
the balance sheet

Term loans often require collateral, but this
represents a secondary source of repayment
in case the borrower defaults.
Term Commercial Loans
 Balloon Payments
 Most
of the principal is due at maturity
 Bullet Payments
 All
of the principal is due at maturity
Short-Term Commercial Loans
 Revolving Credits





A hybrid of short-term working capital loans
and term loans
Typically involves the commitment of funds
for 1 – 5 years
At the end of some interim period, the
outstanding principal converts to a term loan
During the interim period, the borrower
determines how much credit to use
Mandatory principal payments begin once
the revolver is converted to a term loan
Short-Term Commercial Loans
 Agriculture Loans

Proceeds are used to purchase seed, fertilizer
and pesticides and to pay other production
costs


Farmers expect to repay the debt with the
crops are harvested and sold
Long-term loans finance livestock, equipment,
and land purchases

The primary source of repayment is cash flow
from the sale of livestock and harvested crops
in excess of operating expenses
Additional Loan Types
 Consumer Loans

Installment



Require periodic payments of principal and
interest
Credit Card
Non-Installment

For special purposes
 Example: Bridge loan for the down payment on a
house that is repaid from the sale of the previous
house

The average consumer loan is relatively small
and has a maturity of 1 to 4 years
Additional Loan Types
 Venture Capital

A broad term use to describe funding
acquired in the earlier stages of a firm’s
economic life


Due to the high leverage and risk involved
banks generally do not participate directly in
venture capital deals
Some banks have subsidiaries that finance
certain types of equity participations and
venture capital deals, but their participation is
limited
Additional Loan Types
 Venture Capital
 This
type of funding is usually acquired
during the period in which the company
is growing faster than its ability to
generate internal financing and before
the company has achieved the size
needed to be efficient
Additional Loan Types
 Venture Capital

Venture capital firms attempt to add value to
the firm without taking majority control


Often, venture capital firms not only provide
financing but experience, expertise, contacts,
and advice when required
Types of Venture Financing

Seed or Start-up Capital
 Early stages of financing
 Highly levered transactions in which the venture
capital firm will lend money for a percentage stake in
the firm
 Rarely, if ever, do banks participate at this stage
Additional Loan Types
 Venture Capital

Types of Venture Financing

Later-Stage Development Financing:





Expansion and replacement financing
Recapitalization or turnaround financing
Buy-out or buy-in financing
Mezzanine Financing
Banks do participate in these rounds of
financing, but if the company is overleveraged
at the onset, the banks will be effectively
excluded from these later rounds of financing
Bank Management, 6th edition.
Timothy W. Koch and S. Scott MacDonald
Copyright © 2006 by South-Western, a division of Thomson Learning
Evaluating Commercial
Loan Request
Chapter 11
Two types of errors in judgment regarding
lending :
 Type I Error
 Making
a loan to a customer who will
ultimately default
 Type II Error
 Denying
a loan to a customer who
would ultimately repay the debt.
Five key questions/issues:
1.
2.
3.
4.
5.
What is the character of the borrower and
the quality of information provided?
What are the loan proceeds going to be
used for?
How much does the customer need to
borrow?
What is the primary source of repayment
and when?
What collateral is available ?
(Secondary source of repayment)
Four steps in evaluating credit requests
1. Overview of management and
operations
2. Spread the financial statements
3. Cash flow analysis
4. Pro forma projections and analysis
Overview of management and operations
 Gather information on:
 Business
and related industry
 Management quality
 Nature of loan request
 Quality of the data
Spread the financials
 Spread the financials and compute
common size ratios
 Compare
with industry averages
 Compare over time (trend analysis)
 Calculate a series of financial
ratios that indicate performance
and risk
 Compare
with industry averages
 Compare over time
Wades Office Furniture - Income Statement
Wades Office Furniture
Unaudited: , SIC #2522
INCOME STATEMENT
[- H I S T O R I C A L -]
2002
% of
% Cha $ 1,000 Total
[- H I S T O R I C A L -]
2003
% of
% Cha $ 1,000 Total
[- H I S T O R I C A L -]
2004
% of
% Cha $ 1,000 Total
RMA
6/30/03 3/31/04
Net sales
Cost of goods sold
Gross profit
#N/A
#N/A
#N/A
7,571 100.0% 8.10%
5,089 67.2% 6.58%
2,482 32.8% 11.20%
8,184 100.0%
5,424 66.3%
2,760 33.7%
51.88% 12,430 100.0%
52.19% 8,255 66.4%
51.27% 4,175 33.6%
Selling expenses
Management salaries
General & administrative expenses
Research and development expenses
Depreciation & amortization
Other operating expenses
Total operating expenses
#N/A
#N/A
#N/A
#N/A
#N/A
#N/A
#N/A
906
0
1,019
0
70
0
1,995
1,026
0
1,211
0
71
0
2,308
12.5%
0.0%
14.8%
0.0%
0.9%
0.0%
28.2%
58.67%
0.00%
39.47%
0.00%
2.82%
0.00%
46.88%
1,628
0
1,689
0
73
0
3,390
13.1%
0.0%
13.6%
0.0%
0.6%
0.0%
27.3%
25.7%
#N/A
487
452
5.5%
73.67%
785
6.3%
7.0%
#N/A
#N/A
#N/A
#N/A
#N/A
#N/A
#N/A
0
0
141
0
63
0
(204)
0.0% 0.00%
0.0% 0.00%
1.9% -15.60%
0.0% 0.00%
0.8% 36.51%
0.0% 0.00%
-2.7% 0.49%
0
0
119
0
86
0
(205)
0.0%
0.0%
1.5%
0.0%
1.1%
0.0%
-2.5%
0.00%
0.00%
31.93%
0.00%
17.44%
0.00%
25.85%
0
0
157
0
101
0
(258)
0.0%
0.0%
1.3%
0.0%
0.8%
0.0%
-2.1%
#N/A
283
3.7% -12.72%
247
3.0% 113.36%
527
4.2%
Income taxes
Extraordinary and other income (exp.)
Net income
#N/A
#N/A
#N/A
100
0
183
1.3%
0.0%
2.4%
-5.00%
0.00%
-16.9%
95
0
152
1.2%
0.0%
1.9%
97.89%
0.00%
123.0%
188
0
339
1.5%
0.0%
2.7%
Dividends
Retained earnings
#N/A
#N/A
0
183
0.0% 0.00%
2.4% -16.94%
0
152
0.0%
0.00%
1.9% 123.03%
0
339
0.0%
2.7%
Operating profit
Interest on marketable securities
Income on long term investments
Interest expense - Bank Notes
Interest expense - Term notes + LTD
All other expenses
All other income
Total All Other Income (Expenses)
Profit before taxes
12.0% 13.25%
0.0% 0.00%
13.5% 18.84%
0.0% 0.00%
0.9% 1.43%
0.0% 0.00%
26.4% 15.69%
6.4%
-7.19%
100.0%
67.3%
32.7%
6.2%
Historical Balance Sheet (Assets)
Wades Office Furniture
Unaudited: , SIC #2522
BALANCE SHEET
[- H I S T O R I C A L -]
2002
% of
% Cha $ 1,000 Total
[- H I S T O R I C A L -]
2003
% of
% Cha $ 1,000 Total
[- H I S T O R I C A L -]
2004
% of
% Cha $ 1,000 Total
RMA
6/30/03 3/31/04
ASSETS
Cash
Marketable securities
Accounts receivable
Inventory
Prepaid expenses
Deferred tax asset
Other current assets
Current assets
#N/A
#N/A
#N/A
#N/A
#N/A
#N/A
#N/A
#N/A
141
0
1,254
1,160
47
0
0
2,602
4.3% -5.67%
0.0%
0.00%
38.4% 11.56%
35.6%
3.88%
1.4%
6.38%
0.0%
0.00%
0.0%
0.00%
79.7%
7.11%
133
0
1,399
1,205
50
0
0
2,787
3.9%
0.0%
40.8%
35.2%
1.5%
0.0%
0.0%
81.4%
-45.86%
0.00%
35.53%
46.39%
-70.00%
0.00%
0.00%
34.45%
72
0
1,896
1,764
15
0
0
3,747
1.6%
0.0%
42.3%
39.4%
0.3%
0.0%
0.0%
83.6%
Gross fixed assets
Leasehold improvements
Less accumulated dep.
Net fixed assets
#N/A
#N/A
#N/A
#N/A
629
198
206
621
19.3%
7.15%
6.1%
2.02%
6.3% 34.47%
19.0% -3.54%
674
202
277
599
19.7%
5.9%
8.1%
17.5%
17.36%
17.82%
24.91%
14.02%
791
238
346
683
17.7%
5.3%
7.7%
15.2%
28.2%
Notes & contracts receivable
Long-term investments
Intangible assets
Other noncurrent assets
Total Assets
#N/A
#N/A
#N/A
#N/A
#N/A
0
0.0%
0
0.0%
50
1.1%
0
0.0%
4,480 100.0%
0.4%
5.0%
100.0%
0
0.0%
0
0.0%
40
1.2%
0
0.0%
3,263 100.0%
0.00%
0.00%
-2.50%
0.00%
4.96%
0
0.0%
0.00%
0
0.0%
0.00%
39
1.1% 28.21%
0
0.0%
0.00%
3,425 100.0% 30.80%
5.5%
28.8%
29.7%
2.4%
66.4%
Historical Balance Sheet (Liabilities and Equity)
Wades Office Furniture
Unaudited: , SIC #2522
BALANCE SHEET
[- H I S T O R I C A L -]
2002
% of
% Cha $ 1,000 Total
[- H I S T O R I C A L -]
2003
% of
% Cha $ 1,000 Total
[- H I S T O R I C A L -]
2004
% of
% Cha $ 1,000 Total
RMA
6/30/03 3/31/04
LIABILITIES & EQUITY
Notes payable - bank
Accounts payable
Accrued expenses
Income tax payable
Current maturity - Term notes
Current maturity - LTD
Other current liabilities
Current liabilities
#N/A
#N/A
#N/A
#N/A
#N/A
#N/A
#N/A
#N/A
643
836
205
41
0
75
0
1,800
19.7% -9.49%
25.6%
8.61%
6.3% 25.85%
1.3% 51.22%
0.0%
0.00%
2.3%
0.00%
0.0%
0.00%
55.2%
4.72%
582
908
258
62
0
75
0
1,885
17.0%
26.5%
7.5%
1.8%
0.0%
2.2%
0.0%
55.0%
53.26%
41.19%
34.88%
27.42%
0.00%
0.00%
0.00%
41.96%
892
1,282
348
79
0
75
0
2,676
19.9%
28.6%
7.8%
1.8%
0.0%
1.7%
0.0%
59.7%
6.0%
14.0%
Deferred tax liability
Term notes
Long-term debt (LTD)
Other noncurrent liabilities
Total liabilities
#N/A
#N/A
#N/A
#N/A
#N/A
0
0
450
0
2,250
0.0%
0.00%
0.0%
0.00%
13.8% -16.67%
0.0%
0.00%
69.0%
0.44%
0
0
375
0
2,260
0.0%
0.00%
0.0%
0.00%
10.9% -20.00%
0.0%
0.00%
66.0% 31.68%
0
0
300
0
2,976
0.0%
0.0%
6.7%
0.0%
66.4%
20.1%
0.9%
58.1%
Common stock - par
#N/A
Paid-in surplus
#N/A
Preferred stock
#N/A
Treasury and other equities
#N/A
Retained earnings
#N/A
Stockholder's equity
#N/A
Total Liabilities and Equity#N/A
600
100
0
0
313
1,013
3,263
18.4%
0.00%
3.1%
0.00%
0.0%
0.00%
0.0%
0.00%
9.6% 48.56%
31.0% 15.00%
100.0%
4.96%
600
100
0
0
465
1,165
3,425
17.5%
0.00%
2.9%
0.00%
0.0%
0.00%
0.0%
0.00%
13.6% 72.90%
34.0% 29.10%
100.0% 30.80%
600
100
0
0
804
1,504
4,480
13.4%
2.2%
0.0%
0.0%
17.9%
33.6%
100.0%
41.9%
100.0%
1.7%
3.6%
11.8%
37.1%
Ratio analysis
 Liquidity and activity ratios
 Leverage ratios
 Profitability ratios
Liquidity and activity ratios
 Net Working Capital = CA - CL
 Current Ratio = CA / CL
 Quick Ratio = (CA – Inv.) / CL
 Days Cash = Cash / Avg. daily sales
 Inventory Turnover = COGS / Avg. Inv.
 AR Collection (Days A/R) = (A/R) / Avg. daily sales
 Days Cash to Cash
= Days Cash + Days A/R + Days inventory
 Days Payable Outstanding =AP / Avg. daily pur.
= AP / [(COGS + Inventory) / 365]
 Sales to net fixed assets = Sales / Net fixed assets
Wades Office Furniture: Liquidity Ratios
Wades Office Furniture
Unaudited: , SIC #2522
FINANCIAL RATIOS
Credit sales
[- H I S T O R I C A L -]
[- H I S T O R I C A L -]
[- H I S T O R I C A L -]
RMA
2002
2003
2004
$ 1,000
$ 1,000
$ 1,000
6/30/03 3/31/04
$ 7,571
$ 8,184
$ 12,430
1.45
0.78
Days Times
6.80 53.70 x
60.46 6.04 x
83.20 4.39 x
150.45
48.83 7.47 x
59.96 6.09 x
1.48
0.81
Days Times
5.93 61.53 x
62.39 5.85 x
81.09 4.50 x
149.41
60.60 6.02 x
61.10 5.97 x
1.40
1.70
0.74
0.90
Days
Times Days Times
2.11 172.64 x
55.67
6.56 x 45.0
8.1x
78.00
4.68 x 65.0
5.6x
135.79
53.09
6.88 x 32.0 11.3x
56.68
6.44 x
11.3x
101.62
$1,417
88.81
$1,320
82.70
$1,870
Liquidity Ratios
Current Ratio
Quick Ratio
Days Cash
Days Accts Receivable (Turnover)
Days Inventory (Turnover)
Cash-to-cash asset cycle
Days AP Outstanding (Turnover)
Memo: COGS / Accounts payable
Days Cash to Cash Cycle
Est. W.C. financing Needs
3.59 x
4.11 x
4.41 x
Leverage ratios
 Debt Ratio = Debt / Total assets
 Debt to tangible net worth = Debt / Tang. NW
 Times interest earned = EBIT / Int. exp.
where,
EBIT = Earns before tax plus int. exp.
 Fixed Charge Coverage
= (EBIT+lease pay) / (Int. exp.+ lease pay)
 Net Fixed Assets to Tangible NW
 Dividend Payout %
= Dividends paid / Net profit
Wades Office Furniture: Leverage
Ratios
Wades Office Furniture
Unaudited: , SIC #2522
FINANCIAL RATIOS
[- H I S T O R I C A L -]
[- H I S T O R I C A L -]
[- H I S T O R I C A L -]
RMA
2002
2003
2004
$ 1,000
$ 1,000
$ 1,000
6/30/03 3/31/04
Leverage Ratios
Debt to Tangible Net Worth
2.31 x
Times Interest Earned
3.01 x
Fixed Charge Coverage
1.96 x
Net Fixed Assets to Tangible Net Worth 63.82%
Dividend Payout
0.00%
2.01 x
3.08 x
1.79 x
53.20%
0.00%
2.05 x
4.36 x
2.09 x
46.97%
0.00%
1.7x
5.3x
1.7x
50.0%
Profitability ratios
 Return on Equity (ROE)
= Net income / Total equity

Profit before taxes to net worth
= Profit before taxes / Tangible net worth
 Return on Assets (ROA) = Net income / Total assets

Profit before taxes to total assets
= Profit before taxes / Total assets
 Asset utilization (AU)= Sales / Total assets
sometimes referred to as asset turnover
 Profit margin (PM) = Net income / Sales
 Sales growth =
Sales / Last period’s sales
 Income taxes to profit before taxes
= Reported income tax / Profit before taxes
Wades Office Furniture: Profitability
Ratios
Wades Office Furniture
Unaudited: , SIC #2522
FINANCIAL RATIOS
[- H I S T O R I C A L -]
[- H I S T O R I C A L -]
[- H I S T O R I C A L -]
RMA
2002
2003
2004
$ 1,000
$ 1,000
$ 1,000
6/30/03 3/31/04
Profitability Ratios
Return on Net Worth (ROE)
Profit Before Taxes to Net Worth
Return on Assets (ROA)
Profit Before Taxes to Total Assets
Equity multiplier (leverage = TA / TE)
18.07%
29.09%
5.61%
8.67%
3.22 x
13.05%
21.94%
4.44%
7.21%
2.94 x
22.54%
36.24%
7.57%
11.76%
2.98 x
Income
Tot. asset turnover (net sales / TA)
All other income / total assets
2.32 x
0.00%
2.39 x
0.00%
2.77 x
0.00%
Expenses
Net profit margin (NI / net sales)
2.42%
COGS / net sales
67.22%
Operating expenses / net sales
26.35%
Income Taxes to Earnings Before Taxes35.34%
1.86%
66.28%
28.20%
38.46%
2.73%
66.41%
27.27%
35.67%
Sales / Net Fixed Assets
13.66 x
18.20 x
12.19 x
27.7%
12.1%
2.4x
2.1x
67.3%
25.7%
Cash flow analysis:
Cash pays a loan not net income
 Cash Assets
n
m
 A  L
i
i 1
j
 NW
j1
 Let A1 = Cash, then:
m
n
j1
i 2
m
n
j1
i 2
m
n
j1
i 2
A1   L j   Ai  NW
 Let NW = stock + surplus + NI - DIV
A1   L j   Ai  stock + surplus + NI - DIV
 Let NI = Revenues - Expenses - Taxes
A1   L j   Ai  stock + surplus
+ Revenues - Expenses - Taxes - DIV
Sources and uses of cash
m
n
j1
i 2
A1   L j   Ai  stock + surplus
+ Revenues - Expenses - Taxes - DIV
 Sources of cash are:
 Increase in any liability
 Decrease in any non-cash asset
 New issues of stock
 Additions to surplus
 Revenues
 Uses of cash are:
 Decrease in any liability
 Increases in any non-cash assets
 Repayment / refunding of stock
 Deductions from surplus
 Cash expenses, taxes, dividends
Understanding sources and uses
 Assets are a use of cash:
 = -(At - At-1)
 Liabilities are a source of cash:
 = +(Lt - Lt-1)
 Revenues are a source of cash:
 = +Revenues
 Expenses are a use of cash:
 = -Expenses
 Sum up each part
There are two types of cash flow statements
1.
Direct


2.
Converts the income statement into a
“cash based income statement.”
Begins with net sales and adjusts for
changes in balance sheet items.
Indirect

Adjusts net income for non-cash charges
and changes in balance sheet items.
Since most financial statements use the
indirect method, we will focus on it.
Four sections in either cash flow statement.
1.
Operations

2.
Investing

3.
Includes all long term assets
Financing

4.
Includes income statement items and all
current assets and current liabilities.
Includes all long term liabilities and equity
(except retained earnings) plus cash
dividends paid.
Cash

Total of the above, but must equal the
actual change in cash and marketable
securities.
Converting the income statement into a cash
based income statement
1.

Operating:
Cash sales:




+ Net Sales
-  Accounts receivables
= Cash sales
Cash purchases (negative value):





- COGS
- Inventory
+ Accounts payable
= Cash purchases
= Cash gross margin
Converting the income statement into a cash
based income statement (continued)
Operating (continued):
 Cash operating expenses (negative value):





- Operating expenses
+ Non-cash charges (dep. and amortization.)
-  Prepaid expenses
+  Accruals
= Cash operating expenses
 Other expenses and taxes:
 - Other expenses + Other income
 - Reported taxes
 +  Income tax payables and deferred inc. tax
 = Other expenses and taxes
 = Cash flow from operations (CFO)
Cash based income statement (cont.)
2. Investing:
 - Capital Exps. = Net fixed assets + depreciation
 - Other long term assets

= Cash used for Investing.
3. Financing:
 - Payments for last periods current maturity debt
 - Payments for dividends

= Payments for financing
 + Debt + EOP CM L-T debt
 + New stock issues

= External Financing
4. = Change in cash and marketable securities
Wades Office Furniture
[- H I S T O R I C A L[--]H I S T O R I C A L[--]H I S T O R I C A L -]
Unaudited: , SIC #2522
CASH BASED INCOME STATEMENT
Net sales
Change in accounts receivable
Cash receipts from sales
Cost of goods sold
Change in inventory
Change in accounts payable
Cash purchases
Cash margin
Total operating expenses
Depreciation & amortization
Change in prepaid expenses
Change in accruals
Change in other current assets & liab.
Cash operating expenses
Cash operating profit
2002
$ 1,000
2003
$ 1,000
2004
$ 1,000
7,571
#N/A
#N/A
8,184
(145)
8,039
12,430
(497)
11,933
(5,089)
#N/A
#N/A
#N/A
(5,424)
(45)
72
(5,397)
(8,255)
(559)
374
(8,440)
2,642
3,493
(2,308)
71
(3)
53
0
(2,187)
(3,390)
73
35
90
0
(3,192)
#N/A
(1,995)
70
#N/A
#N/A
#N/A
#N/A
#N/A
455
301
Interest on marketable securities
Income on long term investments
All other expenses & income (net)
Cash before interest & taxes
0
0
(63)
#N/A
0
0
(86)
369
0
0
(101)
200
Interest expense - Bank notes
Interest expense - Term notes and LTD
Income taxes reported
Change in income tax payable
Change in deferred income taxes
(141)
0
(100)
#N/A
#N/A
(119)
0
(95)
21
0
(157)
0
(188)
17
0
Cash flow from operations (CFO)
#N/A
176
(128)
Wades Office Furniture
[- H I S T O R I C A L[--]H I S T O R I C A L[--]H I S T O R I C A L -]
Unaudited: , SIC #2522
CASH BASED INCOME STATEMENT
Cash flow from operations (CFO)
2002
$ 1,000
2003
$ 1,000
2004
$ 1,000
#N/A
176
(128)
Capital exp. and leasehold improvements
Change in long-term investments
Change in intangible assets
Change in other noncurrent assets
Cash Used for Investments
#N/A
#N/A
#N/A
#N/A
#N/A
(49)
0
1
0
(48)
(157)
0
(11)
0
(168)
Payment for last period's CM Term note
Payment for last period's CMLTD
Dividends paid (DIV)
Payments for financing
#N/A
#N/A
0
#N/A
0
(75)
0
(75)
0
(75)
0
(75)
#N/A
53
(371)
Change in short-term bank debt
Change in term notes & EOP CM term notes
Change in LT debt + EOP CMLTD
Change in stock & surplus
Change in preferred stock
Change in treasury and other equities
Change in other noncurrent liabilities
External financing
#N/A
#N/A
#N/A
#N/A
#N/A
#N/A
#N/A
#N/A
(61)
0
0
0
0
0
0
(61)
310
0
0
0
0
0
0
310
Extraordinary exp. and cha. In acct. prin.
Current period accounting adjustment
0
(130)
0
0
0
0
Change in cash & mktbl securities
#N/A
(8)
(61)
#N/A
(8)
(61)
Cash before external financing
Actual change in cash
Projections of financial condition
 Pro Forma projections of the borrower’s
condition reveal:



How much financing is required.
When the loan will be repaid.
Use of the loan.
 Pro Forma Projections
 Determine critical and non critical
assumptions.
 Use industry projections, internal projections
and judgment to determine sales projections.
In general, grow revenue and trace through the
financial statements.
Pro Forma: Income Statement
 Sales2005
= Sales2004 x (1 + gsales)
= $12,430 x (1 + 0.20) = $14,916
 COGS2005
= Sales2005 x COGS % of Sales
= $14,916 x 0.68 = $10,143
 Sell. Exp2005 = Sales2005 x Selling Exp. % of Sales
= $14,916 x 0.13 = $1,939
 G&A Exp2005 = Sales2005 x G&A Exp. % of Sales
= $14,916 x 0.122 = $1,820
 Int. Exp2005
= (Bank debt2005 x rate on bank debt)
+ (L.T. debt2005 x rate on L.T. debt)
= $697 x 0.145
+ [($75 + $50 + $350 + $225) x 0.09]
= $186
Pro Forma: Balance Sheet (Assets)
Associate balance sheet items with sales.
 AR2005
= Days A/R x Average Daily Sales2005
= 50
x ($14,916 / 365) = $2,043
 Inventory2005 = COGS2005 / Inventory turnover
= $10,143 / 4.9 = $2,070
Capital expenditures from the capital budget:
 Gross fixed (GFA)2005 = GFA2004 + Cap. Exp.2005
= $791
+ $400 = $1,191
 Accumulated depreciation2005
=Acc. Dep.2004 + depreciation exp.2005
= $346
+ $110 = $973
Determine appropriate turnover rates from historical
trends or industry averages.
Pro Forma: Balance Sheet (Liabilities)
Trade credit may be tied to inventory growth, thus
accounts payable tied to inventory growth:
AP2005 = Days AP x Avg. Daily purchases2005
= Days AP x ((COGS2005 + Inv.2005) / 365)
= 53
x ($10,143 + ($2,070 – $1,764) / 365)
= $1,517
Principal payments on debt can be obtained from the
capital budget:
LTD2005 = LTD2004 + New LTD2005 – CM LTD2005
= $300 + $0
– $75
= $225
Term notes (TN)2005 = TN2004 + New TN2005 – CM TN2005
= $0 + $400
– $50
= $350
Note: CM = Current maturity
Pro Forma: Balance Sheet (Equity)
Balance sheet definitions:
 Retained earnings (RE)2005
= RE2004 + (NI2005 – Div.2005) + Acct Adjust.
= $804 + ($339 – $0)
+0
= $1,893
 Stock2005 = Stock2004 + New stock issues
Note: an accounting adjustment is only
needed when adjustments have been made
to retained earnings.
Pro Forma: Determining the “Plug Figure”
Sales growth will determine growth in
receivables, inventory and profit.
 Net Income varies directly with sales in a stable
environment.
The difference in projected asset base and total
funding without new debt determines additional credit
needed or the Plug figure.


When Assets2005 > (Liabilities2005 + Net worth2005)
→Additional financing is required (notes payable plug):

Notes payable2005 = A2005 – (L2005 + NW2005)
When Assets2005 < (Liabilities2005 + Net worth2005)
→ Surplus cash, invest (marketable securities (plug):
Mkt. securities 2005 = – (A2005 – (L2005 + NW2005))
Wades financial projections assumptions: Most
likely circumstances, income statement










Sales increase by 20 percent annually.
Cost of goods sold equals 68 percent of sales.
Selling expenses average 13 percent of sales,
G&A expenses average 12.2 percent of sales
Depreciation equals $110,000 annually.
Noninterest expense equals $110,000 in 2005 and
$135,000 in 2006.
Interest expense equals 14.5 percent of bank debt
and 9 percent of other long-term debt.
Income taxes equal 36 percent of earnings before
taxes
Income tax payable increases annually by the rate
of change in 2004.
No dividends are paid.
Wades financial projections assumptions: Most
likely circumstances, balance sheet
 A/R collection improves to:







50 in 2005 and 46 in 2006.
Inventory turnover increases to:
4.9 in 2005 and 5.1 times in 2006.
Days AP outstanding remains constant at 53.
Prepaid expenses increase by $5,000
Accruals increase by $20,000 annually.
$400,000 is loaned to purchase new equipment, with
the principal repaid in 8 equal annual installments.
 depreciation on the new equip. $40,000, while
depreciation on old will be $70,000 per year.
The minimum cash required is $120,000.
Other assets remain constant at $50,000.
Wades Office Furniture
Unaudited: , SIC #2522
INCOME STATEMENT
[- H I S T O R I C A L -]
2004
% of
% Cha $ 1,000 Total
[-- P R O F O R M A --]
2005
% of
% Cha $ 1,000 Total
[-- P R O F O R M A --]
2006
% of
% Cha $ 1,000 Total
Net sales
Cost of goods sold
Gross profit
51.88% 12,430 100.0% 20.00% 14,916 100.0% 20.00% 17,899 100.0%
52.19% 8,255 66.4% 22.87% 10,143
68.0% 20.00% 12,171
68.0%
51.27% 4,175 33.6% 14.33% 4,773
32.0% 20.00% 5,728
32.0%
Selling expenses
Management salaries
General & administrative expenses
Research and development expenses
Depreciation & amortization
Other operating expenses
Total operating expenses
58.67%
0.00%
39.47%
0.00%
2.82%
0.00%
46.88%
1,628
0
1,689
0
73
0
3,390
73.67%
785
0.00%
0.00%
31.93%
0.00%
17.44%
0.00%
25.85%
0
0
157
0
101
0
(258)
113.36%
527
4.2%
97.89%
0.00%
123.0%
0.00%
123.03%
Operating profit
Interest on marketable securities
Income on long term investments
Interest expense - Bank Notes
Interest expense - Term notes + LTD
All other expenses
All other income
Total All Other Income (Expenses)
Profit before taxes
Income taxes
Extraordinary and other income (exp.)
Net income
Dividends
Retained earnings
13.1% 19.11%
0.0%
0.00%
13.6%
7.74%
0.0%
0.00%
0.6% 50.68%
0.0%
0.00%
27.3% 14.12%
6.3%
15.20%
1,939
0
1,820
0
110
0
3,869
13.0% 20.00%
0.0%
0.00%
12.2% 20.00%
0.0%
0.00%
0.7%
0.00%
0.0%
0.00%
25.9% 19.43%
2,327
0
2,184
0
110
0
4,621
13.0%
0.0%
12.2%
0.0%
0.6%
0.0%
25.8%
1,107
6.2%
904
6.1%
22.43%
0
0
101
85
110
0
(296)
0.0%
0.0%
0.7%
0.6%
0.7%
0.0%
-2.0%
0.00%
0.00%
-48.49%
-16.47%
22.73%
0.00%
-12.84%
0
0
52
71
135
0
(258)
0.0%
0.0%
0.3%
0.4%
0.8%
0.0%
-1.4%
15.41%
608
4.1%
39.60%
849
4.7%
188
0
339
1.5% 16.46%
0.0%
0.00%
2.7%
14.8%
219
0
389
1.5% 39.60%
0.0%
0.00%
2.6%
39.6%
306
0
543
1.7%
0.0%
3.0%
0
339
0.0%
0.00%
2.7% 14.82%
0
389
0.0%
0.00%
2.6% 39.60%
0
543
0.0%
3.0%
0.0%
0.00%
0.0%
0.00%
1.3% -35.62%
0.0% #N/A
0.8%
8.91%
0.0%
0.00%
-2.1% 14.76%
Pro forma Projections: Wades Office Furniture
Balance Sheet (Assets)
Wades Office Furniture
[- H I S T O R I C A L -]
2004
% of
% Cha $ 1,000 Total
[-- P R O F O R M A --] [-- P R O F O R M A --]
2005
% of
2006
% of
% Cha $ 1,000 Total % Cha $ 1,000 Total
Cash
Marketable securities
Accounts receivable
Inventory
Prepaid expenses
Deferred tax asset
Other current assets
Current assets
-45.86%
0.00%
35.53%
46.39%
-70.00%
0.00%
0.00%
34.45%
72
0
1,896
1,764
15
0
0
3,747
66.67%
0.00%
7.77%
17.35%
33.33%
0.00%
0.00%
13.51%
120
0
2,043
2,070
20
0
0
4,253
2.3%
0.0%
38.7%
39.2%
0.4%
0.0%
0.0%
80.6%
0.00%
0.00%
10.40%
15.29%
25.00%
0.00%
0.00%
12.56%
120
0
2,256
2,387
25
0
0
4,787
2.1%
0.0%
39.6%
41.9%
0.4%
0.0%
0.0%
84.0%
Gross fixed assets
Leasehold improvements
Less accumulated dep.
Net fixed assets
17.36%
17.82%
24.91%
14.02%
791
238
346
683
17.7% 50.57%
5.3% 0.00%
7.7% 31.79%
15.2% 42.46%
1,191
238
456
973
22.6% 0.00%
4.5% 0.00%
8.6% 24.12%
18.4% -11.31%
1,191
238
566
863
20.9%
4.2%
9.9%
15.1%
Notes & contracts receivable
Long-term investments
Intangible assets
Other noncurrent assets
Total Assets
0.00%
0.00%
28.21%
0.00%
30.80%
Unaudited: , SIC #2522
BALANCE SHEET
ASSETS
1.6%
0.0%
42.3%
39.4%
0.3%
0.0%
0.0%
83.6%
0
0.0% 0.00%
0
0.0% 0.00%
50
1.1% 0.00%
0
0.0% 0.00%
4,480 100.0% 17.77%
0
0.0%
0
0.0%
50
0.9%
0
0.0%
5,276 100.0%
0.00%
0.00%
0.00%
0.00%
8.04%
0
0.0%
0
0.0%
50
0.9%
0
0.0%
5,700 100.0%
Pro forma Projections: Wades Balance Sheet
(Liabilities and Equities)
Wades Office Furniture
Unaudited: , SIC #2522
BALANCE SHEET
[- H I S T O R I C A L -]
2004
% of
% Cha $ 1,000 Total
[-- P R O F O R M A --]
2005
% of
% Cha $ 1,000 Total
[-- P R O F O R M A --]
2006
% of
% Cha $ 1,000 Total
LIABILITIES & EQUITY
Notes payable - bank
Accounts payable
Accrued expenses
Income tax payable
Current maturity - Term notes
Current maturity - LTD
Other current liabilities
Current liabilities
53.26%
41.19%
34.88%
27.42%
0.00%
0.00%
0.00%
41.96%
892
1,282
348
79
0
75
0
2,676
19.9% -21.85%
28.6% 18.35%
7.8%
5.75%
1.8% 27.42%
0.0% #N/A
1.7%
0.00%
0.0%
0.00%
59.7%
4.93%
697
1,517
368
101
50
75
0
2,808
13.2% -48.49%
28.8% 19.52%
7.0%
5.43%
1.9% 27.42%
0.9%
0.00%
1.4%
0.00%
0.0%
0.00%
53.2%
0.20%
359
1,813
388
128
50
75
0
2,814
6.3%
31.8%
6.8%
2.3%
0.9%
1.3%
0.0%
49.4%
0.00%
0.00%
-20.00%
0.00%
31.68%
0
0
300
0
2,976
0.0%
0.00%
0.0% #N/A
6.7% -25.00%
0.0%
0.00%
66.4% 13.68%
0
350
225
0
3,383
0.0%
0.00%
6.6% -14.29%
4.3% -33.33%
0.0%
0.00%
64.1% -3.53%
0
300
150
0
3,264
0.0%
5.3%
2.6%
0.0%
57.3%
Common stock - par
0.00%
Paid-in surplus
0.00%
Preferred stock
0.00%
Treasury and other equities
0.00%
Retained earnings
72.90%
Stockholder's equity
29.10%
Total Liabilities and Equity30.80%
600
100
0
0
804
1,504
4,480
13.4%
0.00%
2.2%
0.00%
0.0%
0.00%
0.0%
0.00%
17.9% 48.41%
33.6% 25.88%
100.0% 17.77%
600
100
0
0
1,193
1,893
5,276
11.4%
0.00%
1.9%
0.00%
0.0%
0.00%
0.0%
0.00%
22.6% 45.54%
35.9% 28.70%
100.0%
8.04%
600
100
0
0
1,737
2,437
5,700
10.5%
1.8%
0.0%
0.0%
30.5%
42.7%
100.0%
Deferred tax liability
Term notes
Long-term debt (LTD)
Other noncurrent liabilities
Total liabilities
Pro forma Projections:
Wades Office Furniture Liquidity and
Leverage
Ratios
Wades
Office Furniture
[- H I S T O R I C A L -]
[-- P R O F O R M A --]
[-- P R O F O R M A --]
2004
2005
$ 1,000
2006
$ 1,000
Unaudited: , SIC #2522
FINANCIAL RATIOS
Credit sales
$ 1,000
$ 12,430
$ 14,916
$ 17,899
Liquidity Ratios
Current Ratio
Quick Ratio
Days Cash
Days Accts Receivable (Turnover)
Days Inventory (Turnover)
Cash-to-cash asset cycle
Days AP Outstanding (Turnover)
Memo: COGS / Accounts payable
Days Cash to Cash Cycle
Est. W.C. financing Needs
1.40
0.74
Days
Times
2.11 172.64 x
55.67
6.56 x
78.00
4.68 x
135.79
53.09
6.88 x
56.68
6.44 x
1.51
0.77
Days
Times
2.94 124.30 x
50.00
7.30 x
74.49
4.90 x
127.43
53.00
6.89 x
54.60
6.69 x
1.70
0.84
Days
Times
2.45 149.16 x
46.00
7.93 x
71.57
5.10 x
120.02
53.00
6.89 x
54.38
6.71 x
82.70
$1,870
74.43
$2,068
67.02
$2,235
4.41 x
4.90 x
Leverage Ratios
Debt to Tangible Net Worth
Times Interest Earned
Fixed Charge Coverage
Net Fixed Assets to Tangible Net Worth
Dividend Payout
2.05 x
4.36 x
2.09 x
46.97%
0.00%
1.84 x
4.27 x
2.19 x
52.79%
0.00%
1.37 x
7.90 x
2.89 x
36.16%
0.00%
5.45 x
Pro forma Projections: Wades Profitability, Cash Flow and
Growth Ratios
Wades Office Furniture
Unaudited: , SIC #2522
FINANCIAL RATIOS
[- H I S T O R I C A L -]
[-- P R O F O R M A --]
[-- P R O F O R M A --]
2004
2005
$ 1,000
2006
$ 1,000
$ 1,000
Profitability Ratios
Return on Net Worth (ROE)
Profit Before Taxes to Net Worth
Return on Assets (ROA)
Profit Before Taxes to Total Assets
Equity multiplier (leverage = TA / TE)
22.54%
36.24%
7.57%
11.76%
2.98 x
20.56%
33.00%
7.38%
11.53%
2.79 x
22.30%
35.58%
9.53%
14.90%
2.34 x
Income
Tot. asset turnover (net sales / TA)
All other income / total assets
2.77 x
0.00%
2.83 x
0.00%
3.14 x
0.00%
Expenses
Net profit margin (NI / net sales)
2.73%
COGS / net sales
66.41%
Operating expenses / net sales
27.27%
Income Taxes to Earnings Before Taxes 35.67%
2.61%
68.00%
25.94%
36.00%
3.04%
68.00%
25.81%
36.00%
Sales / Net Fixed Assets
15.33 x
20.74 x
18.20 x
Cash Flow Ratios
CFO / (DIV + last CMLTD)
CFO / (DIV + last CMLTD + bnk notes)
-1.71
-0.13
CFO / (DIV + last CMLTD & CM Term + bnk Notes)
-0.13
4.24
0.41
0.39
6.17
1.07
0.96
Growth Rates
Sales Growth (annualized)
Cost of Goods Sold
Net Income
Total borrowed debt
Total Assets
51.88%
52.19%
123.03%
-20.00%
30.80%
20.00%
22.87%
14.82%
#N/A
17.77%
20.00%
20.00%
39.60%
-47.62%
8.04%
[-- P R O
Wades Office Furniture
[- H I S T O R I C A L[--] P R O F O R M A [---] P R O F O R M A --]
Unaudited: , SIC #2522
2004
2005
2006
CASH BASED INCOME STATEMENT
$ 1,000
$ 1,000
$ 1,000
Net sales
Change in accounts receivable
Cash receipts from sales
12,430
(497)
11,933
14,916
(147)
14,769
17,899
(213)
17,687
Cost of goods sold
Change in inventory
Change in accounts payable
Cash purchases
(8,255)
(559)
374
(8,440)
(10,143)
(306)
235
(10,214)
(12,171)
(317)
296
(12,192)
3,493
4,555
5,495
(3,390)
73
35
90
0
(3,192)
(3,869)
110
(5)
20
0
(3,744)
(4,621)
110
(5)
20
0
(4,496)
Cash margin
Total operating expenses
Depreciation & amortization
Change in prepaid expenses
Change in accruals
Change in other current assets & liab.
Cash operating expenses
Cash operating profit
301
811
999
Interest on marketable securities
Income on long term investments
All other expenses & income (net)
Cash before interest & taxes
0
0
(101)
200
0
0
(110)
701
0
0
(135)
864
Interest expense - Bank notes
Interest expense - Term notes and LTD
Income taxes reported
Change in income tax payable
Change in deferred income taxes
(157)
0
(188)
17
0
(101)
(85)
(219)
22
0
(52)
(71)
(306)
28
0
Cash flow from operations (CFO)
(128)
318
463
Wades Office Furniture
[- H I S T O R I C A L[--] P R O F O R M A [---] P R O F O R M A --]
Unaudited: , SIC #2522
2004
2005
2006
CASH BASED INCOME STATEMENT
$ 1,000
$ 1,000
$ 1,000
Cash flow from operations (CFO)
Capital exp. and leasehold improvements
Change in long-term investments
Change in intangible assets
Change in other noncurrent assets
Cash Used for Investments
Payment for last period's CM Term note
Payment for last period's CMLTD
Dividends paid (DIV)
Payments for financing
Cash before external financing
Change in short-term bank debt
Change in term notes & EOP CM term notes
Change in LT debt + EOP CMLTD
Change in stock & surplus
Change in preferred stock
Change in treasury and other equities
Change in other noncurrent liabilities
External financing
Extraordinary exp. and cha. In acct. prin.
Current period accounting adjustment
Change in cash & mktbl securities
Actual change in cash
(128)
318
463
(157)
0
(11)
0
(168)
(400)
0
0
0
(400)
0
(75)
0
(75)
0
(75)
0
(75)
(50)
(75)
0
(125)
(371)
(157)
338
310
0
0
0
0
0
0
310
(195)
400
0
0
0
0
0
205
(338)
0
0
0
0
0
0
(338)
0
0
0
0
0
0
0
0
0
0
0
(61)
48
0
(61)
48
0
Bank Management, 6th edition.
Timothy W. Koch and S. Scott MacDonald
Copyright © 2006 by South-Western, a division of Thomson Learning
Evaluating Consumer
Loans
Chapter 12
Consumer Loans
 Consumer loans in the aggregate
currently produce greater percentage
profits for banks than commercial
loans
 This
is true despite the higher default
rates on consumer loans
 Not surprisingly, consumer loan rates
typically exceed commercial loan rates
Profitability Measures for FDIC-Insured
Banks with Different Asset Concentrations
Performance Ratios By Asset Concentration Group
Return on Assets (YTD)
December 31, 2004
5.0%
4.5%
4.0%
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
4.01%
1.23%
1.66%
1.30%
1.18%
Commercial
Lenders
Mortgage
Lenders
1.66%
1.10%
0.76%
International
Banks
Agricultural
Banks
Credit Card
Lenders
Consumer
Lenders
Other
Specialized <
$1 Billion
All Other <
$1 Billion
1.35%
All Other >
$1 Billion
Net Interest Margin (YTD)
December 31, 2004
10.0%
9.05%
8.0%
6.0%
4.71%
4.07%
4.0%
3.86%
3.20%
3.05%
2.50%
3.86%
3.27%
2.0%
0.0%
International Agricultural
Banks
Banks
Credit Card
Lenders
Commercial
Lenders
Mortgage
Lenders
Consumer
Lenders
Other
All Other <
Specialized < $1 Billion
$1 Billion
All Other >
$1 Billion
Net Charge-Offs of FDIC-Insured Banks
with Different Asset Concentrations
Net Charge-offs to Loans and Leases (YTD)
December 31, 2004
5.0%
4.67%
4.0%
3.0%
2.0%
1.0%
1.57%
0.91%
0.59%
0.30%
0.21%
0.12%
0.31%
0.25%
All Other <
$1 Billion
All Other >
$1 Billion
0.0%
International
Banks
Agricultural
Banks
Credit Card
Lenders
Commercial
Lenders
Mortgage
Lenders
Consumer
Lenders
Other
Specialized <
$1 Billion
Consumer Loans
 Evaluating Consumer Loans
 An analyst should addresses the same
issues discussed with commercial
loans:
 The use of loan proceeds
 The amount needed
 The primary and secondary source of
repayment
 However, consumer loans differ so
much in design that no comprehensive
analytical format applies to all loans
Types of Consumer Loans
 Installment Loans
 Require the periodic payment of
principal and interest
 Can be extremely profitable
 Direct
 Negotiated between the bank and the
ultimate user of the funds
 Indirect
 Funded by a bank through a separate
retailer that sells merchandise to a
customer
Types of Consumer Loans
 Credit Cards and Other Revolving Credit

Credit cards and overlines tied to checking
accounts are the two most popular forms of
revolving credit agreements


In 2004 consumers charged approximately
$2.5 trillion on credit cards
Most banks operate as franchises of
MasterCard and/or Visa

Bank pays a one-time membership fee plus an
annual charge determined by the number of
its customers actively using the cards
Types of Consumer Loans
 Credit Cards and Other Revolving
Credit
 Credit
cards are attractive because
they provide higher risk-adjusted
returns than do other types of loans

Card issuers earn income from three
sources:
 Cardholders’ annual fees
 Interest on outstanding loan balances
 Discounting the charges that merchants
accept on purchases.
Credit Card Loss Rates and Personal
Bankruptcy Filings: 1984-2004
Personal Bankruptcy Filings $000
Net Charge-Off %
9%
450
Credit-Card
Charge-Off
Rates
8%
7%
400
350
6%
300
5%
250
Personal
Bankruptcy
Filings
4%
200
3%
2%
150
1%
100
0%
50
'84
'86
'88
'90
'92
'94
'96
'98
'00
'02
'04
Types of Consumer Loans
 Credit Card Systems and Profitability
 Returns
depend on the specific role
the bank plays
A bank is called a card bank if it
administers its own credit card plan or
serves as the primary regional agent of
a major credit card operation
 A non-card bank does not issue its own
card

Credit Card Transaction Process
1
Individual
Retail Outlet
4
Card-Issuing
Bank
2
3
Clearing
Network
3
Local Merchant
Bank
2
Steps
Fees
1. Individual uses a credit card to purchase
merchandise from a retail outlet.
2. Retail outlet deposits the sales slip or
electronically transmits the purchase data
at its local bank.
3. Local merchant bank forwards the
transaction information to a clearing
network, which routes the data to the bank
that issued the credit card to the individual.
4. The card-issuing bank sends the individual
an itemized bill for all purchases.
1. None
2. The merchant bank discounts the sales receipt. A 3
percent discount indicates the bank gives the retailer
$97 in credit for each $100 receipt.
3. The card-issuing bank charges the merchant bank an
interchange fee equal to 1 to 1.5 percent of the
transaction amount for each item handled.
4. The card-issuing bank charges the customer interest
and an annual fee for the privilege of using the card.
A card-issuing bank also serves as a merchant bank.
Debit Cards and Smart Card
 Debit Cards
 Widely
available
 When an individual uses the card, their
balance is immediately debited
 They have lower processing costs to
the bank
Debit Cards and Smart Card
 Smart Card
 An
extension of debit and credit cards
 Contains a memory chip which can
manipulate information
 It is programmable such that users can
store information and recall this
information when effecting
transactions.
 Only modest usage in the U.S.
Debit Cards and Smart Card
 Smart Card
 Usage
will likely increase dramatically
in the U.S.:
Firms can offer a much wider range of
services
 Smart cards represent a link between
the Internet and real economic activity
 Suppliers of smart cards are
standardizing the formats so that all
cards work on the same systems

Pre-Paid Cards
 Prepaid Cards
A
hybrid of debit cards in which
customers prepay for services to be
rendered and receive a card against
which purchases are charged
 Use of phone cards, prepaid cellular,
toll tags, subway, etc. are growing
rapidly
Types of Consumer Loans
 Overdraft Protection and Open Credit Lines

Overdraft Protection Against Checking
Accounts

A type of revolving credit
 Open Credit Lines


A recent trend is to offer open credit lines to
affluent individuals whether or not they have
an existing account relationship
Typically, the bank provides customers with
special checks that activate a loan when
presented for payment
Types of Consumer Loans
 Home Equity Loans
 Grew from virtually nothing in the mid1980s to over $250 billion in 2004
 They meet the tax deductibility
requirements of the Tax Reform Act of
1986, which limits deductions for
consumer loan interest paid by
individuals, because they are secured
by equity in an individual's home
 Some allow access to credit line by
using a credit card
Types of Consumer Loans
 Non-Installment Loans
 Often
require a single principal and
interest payment

Bridge loans are representative of
single payment consumer loans.
 Bridge loans often arise when an individual
borrows funds for the down payment on a
new house
 The loan is repaid when the borrower sells
the previous home
Subprime Loans
 One of the hottest growth areas during
the 1990s
 Subprime
loans are higher-risk loans
labeled “B,” “C,” and “D” credits
They have been especially popular in
auto, home equity, and mortgage
lending
 Typically have the same risk as loans
originated through consumer finance
companies

Subprime Loans
 Subprime loans have greater risk and must be priced
consistently higher than prime-grade loans
 Example Definitions:



B: Typically scores 600+ under the Fair Isaac system; has
some 90-day past dues but is now current. Typical
delinquencies are 2%-5%; repossessions are 2.5%-6%;
and losses are 1.5%-3%
C: Typically scores between 500 and 600 and has had
write-offs and judgments. The borrower has made
subsequent payments of some or all of the loans. Typical
delinquencies are 5%-10%; repossessions, 5%-20%; and
losses 3%-10%
D: Typically scores between 440 and 500 and has chargeoffs and judgments that have not been repaid and has
not made payments on these loans. Delinquencies are
10%-20%; repossessions, 16%-40%; losses, 10%-20%
Subprime Loans
 High LTV Loans
 High
Loan-To-Value
Many lenders upped the stakes by
making “high LTV” loans based on the
equity in a borrower’s home
 Where traditional home equity loans are
capped at 75 percent of appraised value
minus the outstanding principal
balance, high LTV loans equal as much
as 125% of the value of a home

Consumer Credit Regulations
 Equal Credit Opportunity
 Makes it illegal for lenders to
discriminate
 Prohibits Information Requests on:
 The applicant's marital status
 Whether alimony, child support, and
public assistance are included in
reported income
 A woman's childbearing capability and
plans
 Whether an applicant has a telephone
Consumer Credit Regulations
 Equal Credit Opportunity
 Credit
Scoring Systems
Credit scoring systems are acceptable if
they do not require prohibited
information and are statistically justified
 Credit scoring systems can use
information about age, sex, and marital
status as long as these factors
contribute positively to the applicant's
creditworthiness

Consumer Credit Regulations
 Equal Credit Opportunity
 Credit
Scoring Systems
Credit scoring models are based on
historical data obtained from applicants
who actually received loans
 Statistical techniques assign weights to
various borrower characteristics that
represent each factor's contribution
toward distinguishing between good
loans that were repaid on time and
problem loans that produced losses

Consumer Credit Regulations
 Equal Credit Opportunity
 Credit
Reporting
Lenders must report credit extended
jointly to married couples in both
spouses' names
 Whenever lenders reject a loan, they
must notify applicants of the credit
denial within 30 days and indicate why
the request was turned down

Consumer Credit Regulations
 Truth In Lending
 Regulations apply to all individual loans
up to $25,000 where the borrower's
primary residence does not serve as
collateral
 Requires that lenders disclose to
potential borrowers both the total
finance charge and an annual
percentage rate (APR)
 The APR equals the total finance charge
computed against the loan balance as a
simple annual interest rate equivalent
Consumer Credit Regulations
 Truth In Lending
 Historically, consumer loan rates were
quoted as add-on rates, discount rates,
or simple interest rates
 Add-on Rates
 Applied against the entire principal of
installment
 Gross interest is added to the principal
with the total divided by the number of
periodic payments to determine the size
of each payment
Consumer Credit Regulations
 Add-on Rates
 Applied
against the entire principal of
installment

Gross interest is added to the principal
with the total divided by the number of
periodic payments to determine the size
of each payment
Consumer Credit Regulations
 Add-on Rates

Example:


Suppose that a customer borrows $3,000 for
one year at a 12 percent add-on rate with the
loan to be repaid in 12 equal monthly
installments
Total interest equals $360, monthly payment
equals $280, and the effective annual interest
cost is approximately 21.5%
[0.12($3,0 00)  $3,000]
 $280
12
12
$280
Effective Interest Rate(i) : 
 $3,000 i  21.46%
t
t=1(1 + i)
Monthly Payment 
Consumer Credit Regulations
 Discount Rate Method
 Quoted
rate is applied against the sum
of principal and interest, yet the
borrower gets to use only the principal,
as interest is immediately deducted
from the total loan
Consumer Credit Regulations
 Discount Rate Method
 Example:
 Consider a 1-year loan with a single
$3,000 payment at maturity.
 The borrower receives only $2,640, or the
total loan minus 12% discount rate
interest.
 The effective annual percentage rate, or
APR, equals 13.64%
 Interest charge = 0.12 ($3,000) = $360
$3,000
Annual Percentage Rate (in ) $2,640 =
(1 + in )
i  13.64%
Consumer Credit Regulations
 Simple Interest
 Interest
is paid on only the principal
sum

Example:
 $3,000 loan at 12% simple interest per year
produces $360 in interest, or a 12 percent
effective rate interest (is): =
$3,000(0.12)(1)= $360
$3,360
$3,000 =
(1 + is )
is  12%
Consumer Credit Regulations
 Simple Interest
 The quoted rate (APR) is adjusted to its
monthly equivalent, which is applied
against the unpaid principal balance
on a loan
 The loan is repaid in 12 monthly
installments and the monthly interest
rate equals 1 percent of the
outstanding principal balance at each
month
Consumer Credit Regulations
 Simple Interest
Repayment Schedule
End of Month
Monthly
Interest
Payment
Portion
January
February
March
April
May
June
July
August
September
October
November
December
Total
Principal
$266.55
266.55
266.55
266.55
266.55
266.55
266.55
266.55
266.55
266.55
266.55
266.51
$30.00
27.63
25.25
22.83
20.40
17.93
15.45
12.94
10.40
7.84
5.25
2.64
$236.55
238.92
241.30
243.72
246.15
248.62
251.10
253.61
256.15
258.71
261.30
263.87
$3,198.56
$198.56
$3,000.00
Effective interest rate:
Monthly rate = 1%
Annual precentage rate = 12%
Monthly payment = $3,000
Outstanding
Principal
Balance
$2,763.45
2,524.53
2,283.23
2,039.51
1,793.36
1,544.74
1,293.64
1,040.03
783.88
525.17
263.87
0.00
12
1
 (1.01)
i=1
t
Consumer Credit Regulations
 Fair Credit Reporting Act
 Enables individuals to examine their credit
reports provided by credit bureaus
 If any information is incorrect, the individual
can have the bureau make changes and notify
all lenders who obtained the inaccurate data
 There are three primary credit reporting
agencies:
 Equifax
 Experian
 Trans Union
 Unfortunately, the credit reports that they produce
are quite often wrong
Sa
m
pl
e
Cr
ed
it
Re
po
rt
Consumer Credit Regulations
 Fair Credit Reporting Act
 Credit

Score
Like a bond rating for individuals
 Based on several factors
Factor
Contributing to
Credit Score,
10%
Factor
Contributing to
Credit Score,
15%
Factor
Contributing to
Credit Score,
10%
Factor
Contributing to
Credit Score,
30.00%
Factor
Contributing to
Credit Score,
35%
Consumer Credit Regulations
 Community Reinvestment Act
 CRA prohibits redlining and encourages
lenders to extend credit within their immediate
trade area and the markets where they collect
deposits
 FIRREA of 1989 raised the profile of the CRA
by:
 Mandating public disclosure of bank lending
policies and regulatory ratings of bank
compliance
 Regulators must also take lending performance
into account when evaluating a bank's request
to charter a new bank, acquire a bank, open a
branch, or merge with another institution
Consumer Credit Regulations
 Bankruptcy Reform
 Individuals who cannot repay their debts on
time can file for bankruptcy and receive court
protection against creditors
 Individuals can file for bankruptcy under:
 Chapter 7
 Individuals liquidate qualified assets and distribute
the proceeds to creditors

Chapter 13
 An individual works out a repayment plan with court
supervision.


Unfortunately, individuals appear to be using
bankruptcy as a financial planning tool
It appears the stigma of bankruptcy is largely
gone
Credit Analysis
 Objective of consumer credit analysis is to assess the
risks associated with lending to individuals

When evaluating loans, bankers cite the Cs of credit:
 Character
 The most important element, but difficult to assess
 Capital
 Refers to the individual's wealth position
 Capacity
 The lender often imposes maximum allowable debtservice to income ratios
 Conditions
 The impact of economic events on the borrower's
capacity to pay
 Collateral
 The importance of collateral is in providing a
secondary source of repayment
Credit Analysis
 Two additional Cs
 Customer Relationship
 A bank’s prior relationship with a customer
reveals information about past credit and
deposit experience that is useful in assessing
willingness and ability to repay.
 Competition
 Has an impact by affecting the pricing of a loan.
 All loans should generate positive risk-adjusted
returns
 Lenders periodically react to competitive
pressures by undercutting competitors’ rates in
order to attract new business
 Competition should not affect the accept/reject
decision
Credit Analysis
 Policy Guidelines
 Acceptable
Loans
Automobile
 Boat
 Home Improvement
 Personal-Unsecured
 Single Payment
 Cosigned

Credit Analysis
 Policy Guidelines

Unacceptable Loans







Loans for speculative purposes
Loans secured by a second lien
 Other than home improvement or home
equity loans
Any participation with a correspondent bank in a
loan that the bank would not normally approve
Loans to a poor credit risk based on the
strength of the cosigner
Single payment automobile or boat loans
Loans secured by existing home furnishings
Loans for skydiving equipment and hang gliders
Credit Analysis
 Evaluation Procedures:
 Judgmental
and
 Quantitative, Credit Scoring
Credit Analysis: Judgmental Procedures
 Judgmental
 The
loan officer subjectively interprets
the information in light of the bank’s
lending guidelines and accepts or
rejects the loan
Credit Analysis: Quantitative
 Quantitative credit scoring / Credit
scoring model
 The
loan officer grades the loan request
according to a statistically sound model
that assigns points to selected
characteristics of the prospective
borrower
 In both cases, judgmental and
quantitative, a lending officer collects
information regarding the borrower’s
character, capacity, and collateral
An Application: Credit Scoring a Consumer Loan
 You receive an application for a
customer to purchase a 2003 Jeep
Cherokee
 Do
you make the loan?
Credit scoring system, University National
Bank, applied to credit application for
purchase of a 2003 Jeep
Category
Characteristics/Weights
<$10,000
5
Monthly Debt Payment
>40%
Monthly Net Income
0
Annual Gross Income
Bank Relationship
Checking/Saving
Major Credit Cards
Credit History
Applicant's Age
Residence
Residence Stability
$10,000-$20,000
15
30-40%
5
None
Checking Only
0
30
None
1 or more
0
30
Any derogatory within 7 yrs.
-10
< 50 yrs.
>50 yrs.
5
25
Rent
15
Own/Buying
40
$20,000-$40,000
30
20-30%
20
$40,000-60,000
45
10-20%
35
>$60,000
60
<10%
50
Saving only
Checking & Saving No answer
30
50
0
No answer
0
No record
Met obligated payments
0
30
No answer
0
Own outright
50
No answer
15
< 1 yr.
1-2 yrs.
2-4 yrs.
>4 yrs.
No answer
0
15
35
50
0
Job Stability
< 1 yr.
1-2 yrs.
2-4 yrs.
>4 yrs.
Unemployed Retired
5
20
50
70
5
70
NOTE: Minimum score for automatic credit approval is 200; score for judgmental evaluation, 150 to 1 95; score for
automatic credit denial is less than 150. Melanie Groome's credit score is 185.
FICO Credit Scores
National Distribution of FICO Scores
30
28%
25
20
19%
15
16%
10
12%
5
5%
$% of Population
1%
11%
8%
0 Up to 499 500-549 550-599 600-649 650-699 700-749 750-799
800+
FICO Score Range
Delinquency Rates by FICO Score
100%
80%
60%
40%
20%
0%
87%
71%
51%
31%
15%
5%
2%
Up to 499 500-549 550-599 600-649 650-699 700-749 750-799
Rate of Credit Delinquencies FICO Score Range
1%
800+
An Application: Indirect Lending
 A retailer sells merchandise and takes the
credit application

Because many firms do not have the
resources to carry their receivables, they sell
the loans to banks or other financial
institutions


These loans are collectively referred to as
dealer paper
Banks aggressively compete for paper
originated by well-established automobile,
mobile home, and furniture dealers
An Application: Indirect Lending
 Indirect lending is an attractive form of consumer
lending when a bank deals with reputable retailers
 Dealers negotiate finance charges directly with
their customers
 A bank, in turn, agrees to purchase the paper at
predetermined rates that vary with the default
risk assumed by the bank, the quality of the
assets sold, and the maturity of the consumer
loan
 A dealer normally negotiates a higher rate with
the car buyer than the determined rate charged
by the bank
 This differential varies with competitive
conditions but potentially represents a
significant source of dealer profit
An Application: Indirect Lending
 Most indirect loan arrangements
provide for dealer reserves that reduce
the risk in indirect lending
 The
reserves are derived from the
differential between the normal, or
contract loan rate and the bank rate,
and help protect the bank against
customer defaults and refunds
Terms of the Dealer Agreement
Bank buys dealer paper at a 12 percent rate. Dealer charges customers a higher rate
(15 percent APR), with 25 percent of difference allocated to a reserve.
Sample Automobile Loan
Principal
Maturity
Loan rate
Monthly payment
= $8,000
= 3 years, 36 monthly installments
= 15% annual percentage rate (APR)
= $8,000/[(I/.0125) - (1/.0125(l.0125)36)]
$277.32
Allocation to the Dealer Reserve
Total interest expense to customer = $1,983.52
Total interest income for bank
= 1,565.72
Differential interest
- $ 417.80
75% allocated to dealer: 0.75(417.80)
= $313.35
25% allocated to reserve: 0.25(417.80)
= $104.45
Interest Refunds on Prepayments with Add-on Rates
Loan is written on a precomputed basis, and bank accrues interest using “rule of 78s"*
Interest expense to customer = 0.09($8,000)(3) = $2,160
Interest income for bank
= 0.07($8,000)(3) = 1,680
Differential interest = $ 480
75% allocated to dealer:
0.75($480) = $360
25% allocated to reserve: 0.25($480) = 120
End of Year Interest Earned* Total
1
2
3
Bank Difference
54.96%
$1,187.14
$923.33
$263.81
33.33
719.33
559.94
159.99
11.71
252.93
196.73
56.20
100.00%
$2,160.00
$1,680.00
$480.00
*Rule of 78s factors are 366/666, 222/666, and 78/666, respectively.
Recent Risks and Return Characteristics of
Consumer Loans
 Revenues from Consumer Loans
 The
attraction is two-fold:
Competition for commercial customers
narrowed commercial loan yields so
that returns fell relative to potential
risks
 Developing loan and deposit
relationships with individuals
presumably represents a strategic
response to deregulation

Recent Risks and Return Characteristics of
Consumer Loans
 Revenues from Consumer Loans
 Consumer
loan rates have been among
the highest rates quoted at banks in
recent years
 In addition to interest income, banks
generate substantial non-interest
revenues from consumer loans

With traditional installment credit,
banks often encourage borrowers to
purchase credit life insurance on which
the bank may earn a premium
Recent Risks and Return Characteristics of
Consumer Loans
 Consumer Loan Losses
 Losses
on consumer loans are
normally the highest among all
categories of bank credit
 Losses are anticipated because of
mass marketing efforts pursued by
many lenders, particularly with credit
cards.
 Credit card fraud losses amounted to
more than $2.4 billion in mid-2004
Recent Risks and Return Characteristics of
Consumer Loans
 Interest Rate and Liquidity Risk with
Consumer Credit
 The
majority of consumer loans are
priced at fixed rates
 New auto loans typically carry 4-year
maturities, and credit card loans exhibit
an average 15- to 18-month maturity
Recent Risks and Return Characteristics of
Consumer Loans
 Interest Rate and Liquidity Risk with
Consumer Credit
 Bankers
have responded in two ways:
Price more consumer loans on a
floating-rate basis
 Commercial and investment banks have
created a secondary market in
consumer loans, allowing loan
originators to sell a package of loans
