Commercial Banking Final

Profitability Indicators for Business Customers

1. Before-Tax Net Income / Total Assets 2. After-Tax Net Income / Total Assets 3. Before-Tax Net Income / Net Worth

Expense Control Ratios

1. COGS / Net Sales 2. Wages and Salaries / Net Sales 3. Overhead Expenses / Net Sales 4. Interest Expense / Net Sales 5. Depreciation Expense / Net Sales 6. SG&A Expenses / Net Sales 7. Taxes Owed / Net Sales

Liquidity Indicators for Business Customers

1. Current Ratio = Current Assets / Current Liabilities 2. Acid-Test Ratio = (Current Assets - Inventory) / Current Liabilities 3. Net Liquid Assets = Current Assets - Inventory - Current Liabilities 4. Net Working Capital = Current Assets - Current Liabilities

Marketability of the Customer's Product or Service

1. GPM = (Net Sales - COGS) / Net Sales 2. NPM = Net Income After Taxes / Net Sales

Coverage Ratios

1. Interest Coverage = Income Before Int and Taxes / Interest Payments 2. Coverage of Int and Principal Payments = Income Before Int and Taxes / (Interest Payments + (Principal Repayments / (1 - Firm's Marginal Tax Rate))

Financial Leverage Factors

1. Leverage Ratio = Total Liabilities / Total Assets 2. Capitalization Ratio = Long Term Debt / Total LT Liabilities and Net Worth 3. Debt-to-Sales Ratio = Total Liabilities / Net Sales

What factors should a financial firm consider when choosing a good merger partner?

1. The firm's history, ownership, and management 2. The condition of its balance sheet 3. The firm's track record of growth and operating performance 4. The condition of its income statement and cash flow 5. The condition and prospects of the local economy served by the targeted institution 6. The competitive structure of the market in which the firm operates 7. The comparative management styles of the merging organizations 8. The principal customers the targeted institution serves 9. Current personnel and employee benefits 10. Compatibility of accounting and management information systems among the merging companies 11. Condition of the targeted institution's physical assets 12. Ownership and earnings dilution before and after the proposed merger

Credit scoring system cutoff point for accepting credit requests

360 Credit requests are denied when an applicant's score is below 360.

Are there any significant disadvantages to a credit-scoring system?

A credit-scoring system assumes that the same factors that separated good from bad loans in the past will, with an acceptable risk of error, separate good from bad loans in the future. Clearly, this underlying assumption can be wrong if the economy or other factors change abruptly. Also, from a lending institution's perspective, it runs the risk of alienating those customers who feel the lending institution has not fully considered their financial situation and the special circumstances that may have given rise to their loan request. There is also the danger of being sued by a customer under antidiscrimination laws if race, gender, marital status, or other discriminating factors prohibited by statute or court rulings are used in a scoring system.

What should a good written loan policy contain?

A good written bank loan policy should contain the characteristics and goals of the loan portfolio, the authorities and responsibilities of loaning officers, and clearly laid down operating procedures for loaning funds. It should provide details of the required documentation and collateral. It should define an institution's principal trade area, maximum lending with respect to the institution's capital, minimum acceptable credit ratings, and the process of determination of interest rates chargeable. Methods of dealing with non-performing assets should also be included in the policy.

How is the loan rate figured on a home mortgage loan? What are the key factors or variables?

A home mortgage loan rate is usually based on the market rate of interest plus a premium based on the amount of perceived credit risk of the borrower. It can either be a fixed rate or a floating rate mortgage. One way to figure out the affordability of a home mortgage loan is to calculate the required monthly mortgage payment to be paid by the borrower. This is a time value of money calculation and the payment depends upon the loan principal, the interest rate, and the length of the mortgage loan. An amount where both, the borrower and the lender, agree with each other can be used to set the rate on the mortgage.

What features of a consumer loan application should a loan officer examine most carefully?

A loan officer should examine character and income level of the borrower, purpose of the loan, employment and residential stability of the borrower, and pyramiding of debt when evaluating a consumer loan application.

What are the typical steps followed in receiving a loan request from a customer?

A loan officer usually takes or receives such a request initially and passes it along to the credit analysis division for technical review. Usually the recommendations of both the credit analyst and the loan officer are directed to a loan supervisor or loan committee for approval. The loan committee assesses the possible loan collaterals offered and decides on whether to approve the customer's request. Once approved, the loan committee must monitor to ensure that the terms of the loan are being followed and to address any other service needs that the customer may have.

Should a loan officer ever say "no" to a business firm requesting a loan? Please explain when and where.

A loan request may not appear of having reasonable prospects for being repaid in the future. The loan officer can come to this conclusion after noticing the borrowing company's recent record of sales revenue, expenses, cash flow, and net earnings. Loan officers will inevitably be confronted with such loan requests that will have to be flatly rejected, particularly in those cases where the borrower has falsified information or has a credit history of continually "walking away" from debt obligations. In such cases, the loan officer should be as polite as possible, suggesting to the customer what needs to be changed or improved for the future to permit the customer to be seriously considered for a loan. The officer can offer to provide noncredit services, such as cash management services, advice on a proposed merger, or assistance with a new security offering the customer may be planning. Another possible option is a counteroffer on the proposed loan that is small enough and secured well enough to adequately protect the lender. Also, the loan rate can be shaped in such a way that it further protects and compensates the lender for any risks incurred.

What is a pro forma statement of cash flows, and what is its purpose?

A pro forma statement of cash flows is useful not only to look at historical data in a statement of cash flows, but also to estimate the business borrower's future cash flows and financial condition and its ability to repay the loan.

What does recent research evidence tell us about the impact of most mergers in the financial sector?

A recent study, which looked at the earnings impact of approximately 600 national bank mergers, found no significant differences in profitability between merging and comparably sized nonmerging banks serving the same local markets. However, CEOs at a substantial majority of the nearly 600 U.S. bank mergers believed their capital base improved and they were now a more efficient banking organization. However, as a study by Rose found that there is no guarantee of success in a merger. This study of 572 banks which purchased nearly 650 other banks found a symmetric distribution of earnings outcomes for these mergers—nearly half displaying negative earnings results. Finally, a recent study published by the Federal Reserve Board finds that mergers and acquisition in the financial sector often produce operating cost savings (economies of scale). However, these are generally for small firms and there is no evidence of cost reductions among large financial firms or of any improvements in the management quality.

Why is lending so closely regulated by state and federal authorities?

Access to credit for individuals and businesses is quintessential for any economy. However, irrational lending can sometimes result in huge bad loans for the lending institutions. If a lender is under capitalized, it may even lead to bankruptcy during stressed economic conditions. Empirical evidences suggest that liquidity in banking sector is severely affected due to cascading effects and it takes a long time before free-flow of credit returns in the industry. This has direct fallout on the health of the economy. Regulation also protects consumers against discrimination. Therefore, it is essential that the lending institutions be closely regulated.

Suppose a bank estimates that the marginal cost of raising loanable funds to make a $10 million loan to one of its corporate customers is 4 percent, its nonfunds operating costs to evaluate and offer this loan are 0.5 percent, the default-risk premium on the loan is 0.375 percent, a term-risk premium of 0.625 percent is to be added, and the desired profit margin is 0.25 percent. What loan rate should be quoted to this borrower? How much interest will the borrower pay in a year?

According to the cost-plus loan pricing model: Loan interest rate = Marginal cost of raising loanable funds to lend to the borrower + Nonfunds operating costs + Estimated margin to compensate for default risk + Desired profit margin Loan interest rate = 4% + .5% + .375% + .25% = 5.125% Based on a $10 million loan to bee raised, the customer will pay interest of $10,000,000 x 5.125% = $512,500

What factors seem to motivate most mergers?

Among the most powerful merger motivations are the belief among the stockholders of the firms for greater profit potential if a merger is consummated or their expectation of a possible reduction of cash flow risk or earnings risk. However, from a management's perspective, there is an expectation to gain higher salaries and employee benefits, greater job security, or greater prestige from managing a larger firm. The other various anticipations of merger partners involve the possible rescue of failing institutions, the gaining of a tax advantage where profits of one merger partner may be offset by the losses of another merger partner, and the search for market-positioning benefits in new markets or in superior locations in existing markets. Another motivation is the pursuit of lower cost and greater efficiency so that the merged institution achieves a greater margin of revenues over operating expense as well as maximizing the welfare of management.

What differences exist between ARMs and FRMs?

An ARM or adjustable rate mortgage is a mortgage whose interest rate changes over time, usually based upon changes in some base or reference rate that reflects the cost of funds to the lending institutions. An FRM or fixed rate mortgage is a mortgage whose interest rate does not change throughout the tenure of the loan.

What aspects of a business firm's financial statements do loan officers and credit analysts examine carefully?

Analysis of the financial statements of a business borrower typically begins when the lender's credit analysis department analyses how key figures on the borrower's financial statement have changed (usually during the last three, four, or five years.) The percentage-composition ratios reflected in such financial statements, control for differences in size of firm, permitting the loan officer to compare a particular business customer with other firms and with the industry as a whole. With the help of these ratios, the loan officers and credit analysts examine the following aspects of a business firm's financial statements: a. Control over expenses: A business firm's management keeps a check on its quality by analyzing how carefully it controls its expenses and how well its earnings are likely to be protected and grow. Key financial ratios to monitor a firm's expense control program include, cost of goods sold/net sales; selling, administrative and other expenses/net sales; wages and salaries/net sales; interest expenses on borrowed funds/net sales; overhead expenses/net sales; depreciation expenses/net sales, and taxes/net sales. b. Operating efficiency: It is also important to look at how effectively are assets being utilized to generate sales and how efficiently are sales converted into cash. The important ratios here are, net sales/total assets, annual cost of goods sold/average inventory levels, net sales/net fixed assets, and net sales/accounts and notes receivable. c. Marketability of a product or service: A financial lender can often assess public acceptance of what the business customer has to sell by analyzing such factors as the growth rate of sales revenues, changes in the business customer's share of the available market, and the gross profit margin (GPM) These key factors can be found by computing the following ratios: To measure the gross profit margin the manager has to divide the difference of net sales and cost of goods sold with the net sales. Also, the net profit margin can be found by dividing net income after taxes to net sales. d. Coverage Ratio: The coverage ratio measures the adequacy of earnings to know whether the borrower will be able to pay back the loan. Important measures here include interest coverage which can be computed by dividing the income before interest and taxes by total interest payments, coverage of interest and principal payments can be found by dividing earnings before interest and taxes by the sum of annual interest payments and principal repayments adjusted for the tax effect. Also, the coverage of all fixed payments can be found by dividing income before interest, taxes and lease payments by the sum of interest payments and lease payments. e. Profitability indicators: The ideal standard of performance in a market-oriented economy is how much net income remains for the owners of a business firm after all expenses are charged against revenue. Key barometers of such financial success include the following ratios Before-tax net income/total assets, net worth, or total sales, After-tax net income/total assets (or ROA) After-tax net income/net worth (or ROE) After-tax net income/total sales (or ROS) f. Liquidity indicators: It reflects the borrower's liquidity position so as to raise cash regularly and at a reasonable cost. The lender mainly looks at the borrower's ability to meet the loan payments when they come due. Important ratio measures here usually include the current ratio (current assets/divided by current liabilities), acid-test ratio [(current assets - inventory)/ divided by current liabilities)], net liquid assets (current assets - inventory − current liabilities), and net working capital (current assets − current liabilities). g. Leverage indicators: The term financial leverage refers to use of debt expecting that the borrower can generate earnings that exceed the cost of debt, thereby increasing potential returns to a business firm's owners. Ratios indicating trends in this dimension of business performance usually include the leverage ratio (total liabilities/total assets), capitalization ratio (long-term debt/total long-term liabilities and net worth), and the debt-to-sales ratio (total liabilities/net sales). One problem with employing ratio measures of business performance is that they only reflect symptoms of a possible problem but usually don't tell us the nature of the problem or its causes. Management must look much more deeply into the reasons behind any apparent trend in a ratio. Moreover, any time the value of a ratio changes that change could be due to a shift in the numerator of the ratio, in the denominator, or both.

How is the changing age structure of the population likely to affect consumer loan programs? What other forces are reshaping household lending today?

As people grow older, especially beyond the age of 40 or 45, they tend to make less use of credit and to pay down outstanding debt obligations. This suggests that the total demand for consumer credit per capita may fall, forcing banks and other consumer lenders to fight hard for profitable consumer loan accounts. However, economic prosperity and higher disposable income has allowed many young people to afford housing loans earlier than ever before. Some of the important factors that shape the household lending industry include high consumer demand, effective regulations, and innovations of the financial products that allow institutions to reduce risks on their books and secure more capital, among others.

Many loans to corporations are quoted today at small risk premiums and profit margins over the London Interbank Offered rate (LIBOR). Englewood Bank has a $25 million loan request for working capital to fund accounts receivable and inventory from one of its largest customers, APEX Exports. The bank offers its customer a floating-rate loan for 90 days with an interest rate equal to LIBOR on 30-day Eurodeposits (currently trading at a rate of 4 percent) plus a one-quarter percentage point markup over LIBOR. APEX, however, wants the loan at a rate of 1.014 times LIBOR. If the bank agrees to this loan request, what interest rate will attach to the loan if it is made today? How does this compare with the loan rate the bank wanted to charge? What does this customer's request reveal about the borrowing firm's interest rate forecast for the next 90 days?

At today's prevailing LIBOR rate the customer's requested loan-rate formula would generate a loan interest rate of 1.014 × 4.0 percent = 4.056 percent. However, the bank wanted to charge a rate of 4.0 percent + 0.25 percent = 4.25 percent. Loan rates tend to move up and down faster with the customer's loan-rate formula than with the bank's formula. This customer appears to believe interest rates will decline in a period of 90 days and hence pulls the loan rate lower.

In what ways does the lending function affect the economy of its community or region?

Bank credit is one of the most important sources of capital that fuels local economic growth and development. When banks make loans to support the development of new businesses and to aid the growth of existing businesses, new jobs are created and there is a greater flow of income and spending throughout the local economy.

What are the principal types of loans made by banks?

Bank loans are usually classified by the purpose of the loans. The most common classifications are real estate loans, commercial and industrial loans, loans to financial institutions, credit-card and other loans to individuals, lease financing, and agricultural loans. Bank loans may also be classified by maturity—short term, medium-term, and long-term loans.

What is the CAMELS rating and how is it used?

CAMELS is a rating system used by federal bank examiners to evaluate the overall health of a bank. It is an abbreviation for each of the six factors used to assess the bank. The letters in the word are derived from—Capital adequacy, Asset quality, Management quality, Earnings record, Liquidity position, and Sensitivity to market risk.

What are contingent liabilities, and why might they be important in deciding whether to approve or disapprove a business loan request?

Contingent liabilities are usually not shown on customer balance sheets. These liabilities can be in various forms such as pending or possible future obligations like lawsuits against a business firm, and warranties or guarantees the firm has given to others regarding the quality, safety, or performance of its product or service. Other forms of contingent liabilities that business firms are likely to incur are unfunded pension liabilities the firm will owe toward its employees in the future, taxes owed but unpaid, or limiting regulations. Another example is a credit guarantee in which the firm may have pledged its assets or credit to back up the borrowings of another business, such as a subsidiary. Environmental damage caused by a business borrower has also recently become a great cause of concern of contingent liability for many banks. This is because a bank foreclosing on business property for nonpayment of a loan could become liable for cleanup costs, especially if the bank becomes significantly involved with a customer's business or treats foreclosed property as an investment rather than a repossessed asset that is quickly liquidated to recover the unpaid balance on a loan. Loan officers must be aware of all contingent liabilities because any or all of them could become due and payable claims against the business borrower, weakening the firm's ability to repay its loan to the bank. Hence, it becomes important for the loan officer to ask the customer about pending or potential claims against the firm and then follow up with his or her own investigation, checking government records, public notices, and newspapers.

What is convergence? Product-line diversification? Economies of scale and scope? Why might they be of considerable importance for banks and other financial-service firms?

Convergence is the bringing together firms from different industries in order to create large conglomerates offering multiple services in one place. Product-line-diversification suggests that offering services that are not perfectly correlated with each other has the potential to reduce the risk (variability) of the cash flows of the overall company. Economies of scale means that there might be cost savings from being able to produce a larger number of units of the same product due to greater efficiency and the spreading of a greater volume of output over the firm's fixed costs. Economies of scope means that there are potential costs savings resulting from producing two or more services in one firm. For example, if a single financial firm produces two services, instead of producing only one service, using the same resources, its cost of production may be lower. These things mean that banks and other financial institutions may be more efficient and productive in delivering services to customers either resulting in higher profit margins for companies or cost savings for consumers. These strategies can also result in reduced risk of failure through greater product-line and geographic diversification.

What are the principal strengths and weaknesses of the different loan-pricing methods in use today?

Cost plus pricing is the simplest loan pricing model as it considers the cost of raising loanable funds and the operating costs of running the lending institution. However, the model assumes that a lending institution can accurately judge the costs which often don't turn out to be accurate. Price leadership overcomes the problems of accurately predicting what the costs of a loan will be for a lending institution as major commercial banks establish a uniform base lending fee, the prime rate, Moreover, LIBOR, which is being switched over from prime rates, offer a common pricing standard for all banks, both foreign and domestic, and give customers a common basis for comparing the terms on loans offered by different lenders. However, it is still difficult to assign risk premiums to loans as it would differ among borrowers based on the risk that they carry. Below prime market pricing uses LIBOR as the base rate and includes only a small profit margin as part of the loan price. This has been proposed only for short term loans for large, well known corporations but is not generally used for small and medium sized companies or longer term loans. Customer profitability analysis is similar to cost plus pricing. It however differs from the same technique as in that it considers the whole customer relationship into account when pricing a loan Customer profitability analysis has become increasingly sophisticated as computer models have been designed to help with the analysis. Often the borrowing company itself, its subsidiary firms, major stockholders, and top management are all consolidated into one profitability analysis statement so that the lender receives a comprehensive picture of the total customer relationship. Automated CPA systems permit lenders to plug in alternative loan and deposit pricing schedules to see which pricing schedule works best for both customer and lending institution. CPA can also be used to identify the most profitable types of customers and loans and the most successful loan officers.

How do credit-scoring systems work?

Credit-scoring systems use statistical techniques (usually multiple discriminant analysis) to evaluate the loan applications they receive from consumers. Credit-scoring systems are usually based on discriminant models or related techniques, such as logit or probit analysis or neural networks, in which several variables are used jointly to establish a numerical score for each credit applicant. If the applicant's score exceeds a critical cutoff level, he or she is likely to be approved for credit in the absence of other damaging information. On the contrary, if the applicant's score falls below the cutoff level, credit is likely to be denied in the absence of other mitigating factors.

What is customer profitability analysis? What are its advantages for the borrowing customer and the lender?

Customer profitability analysis is a loan pricing method that takes into account the lender's entire relationship (all revenues and expenses associated with a particular customer) with the customer when pricing the loan. It is based on the difference between revenues from loans and other services provided and expenses from providing loans and other services to the customer is taken over net loanable funds. Net loanable funds are those funds used in excess of the customer's deposits. If the calculated net rate of return from a customer's relationship is positive the loan is made and if it is not, the rate is raised or the loan is not made. As CPA takes the entire relationship of the borrowing company itself, its subsidiary firms, major stockholders, and top management into account, it gives a better picture of which customer relationships are profitable to the lender.

In your opinion, are any additional laws needed in these areas?

Depending on one's point of view, a case can be made, both for and against the requirement of more regulation to protect a consumer's interest. Most, if not all, bankers and bank trade associations, as well as many of the regulatory agencies, tend to agree that there are enough existing laws and regulations in these areas. On the contrary, consumer groups and some elected officials may argue that consumers, particularly in certain economic groups or communities, need more legislations and/or regulation to protect their interests.

What is FICO and what does it do for lenders? Why is this credit-scoring system so popular today?

FICO is a statistics based credit scoring system which computes the scores on the basis of information available in a consumer's credit files. It was developed by Fair Isaac Corporation. Quick and easy access to objective and impartial credit scores makes it very useful tool for lending institutions. In addition to being widely accepted, presence of a FICO score simulator allows individuals to estimate what would happen to their FICO score if certain changes were made in their personal financial profile has made the score popular.

What types of insurance products do banks and a number of their competitors sell today? What advantages could these products offer depository institutions choosing to sell insurance services? Can you see any possible disadvantages?

Financial institutions are starting to offer several insurance products. One product that they offer today is life insurance in which the bank promises to pay a beneficiary a specific cash payment in the event of the death of the policyholder. Another insurance product they are interested in is life insurance underwriting. Here, the institution would manage risks associated with paying life insurance claims. They want to profit from managing insurable risks and collect more in life insurance premiums than they pay in claims. Financial institutions are also getting involved in selling insurance policies for protection from loss due to personal injury, property damage, and other losses associated with property and casualty insurance products. In addition, they also underwrite property/casualty insurance risks. Again, by doing this, they want to collect more in premiums than they have to pay in claims on these contracts. Because of the growth in consolidation of the insurance industry, the financial service providers have been buying out their competitors and emerging as global players. Due to this, these companies seek lower production and marketing costs, diversification of risk exposure beyond one or two countries, and opening up greater revenue potential from what they see as "underinsured" markets (especially in Europe and Asia). On the other hand, selling insurance services requires financial institutions to adhere to strict consumer protection rules. This is practiced because the public may be misled or misinformed. For example, the customer may conclude wrongly that insurance products offered by a depository institution are covered by government-sponsored deposit insurance in case the customer suffers a loss.

How can financial-service customers limit the sharing of their private data by different financial-service firms? In what ways could customer information sharing be useful for financial institutions and for their customers? What possible dangers does information sharing present?

Financial-service firms must inform customers of their policy regarding the sharing of information with other parties. Financial-service firms must also inform customers about how the customer can opt out of having their information shared with other parties. Generally, the customer must inform the company within 30 days of being notified that they do not want their information shared. If the customer fails to notify the service provider of his or her objections to sharing personal data, then the financial-service firm can share at least some of the customer's private information with others, even with outsiders.. This information can be extremely useful to financial institutions because they can use the information to offer more than one service to the customer. They have already gathered the relevant information and can target products and services that are particularly a good fit for that customer. This can benefit them by increasing profits and cash flows and can benefit the customer by allowing them to get all of their financial services needs taken care of in one place. However, there are some real dangers that this information can be misused in some cases. For example, if there is some adverse private information about a particular customer (a very serious medical condition) that information might be used to deny them several financial services (such as getting a new mortgage). This customer essentially becomes blacklisted by many financial-services companies.

Parvis Manufacturing and Service Company holds a sizable inventory of dryers and washing machines, which it hopes to sell to retail dealers over the next six months. These appliances have a total estimated market value currently of $30 million. The firm also reports accounts receivable currently amounting to $24,650,000. Under the guidelines for taking collateral discussed in this chapter, what is the minimum size loan or credit line Parvis is likely to receive from its principal lender? What is the maximum size loan or credit line Parvis is likely to receive?

For advances against accounts receivables, a lender takes a security interest in the form of a stated percentage usually between 40 to 90 percent of the face amount, depending upon the perceived quality of the receivables while for advances against inventories, a lender will usually advance only 30 to 80 percent of the estimated market value of a borrower's inventory to leave a substantial cushion in case of decline in the inventory's value. Therefore, the minimum size loan or credit line for Parvis will be: $30 x 0.3 + $24.65 x 0.4 = $18.86 million And the maximum size loan or credit line for Parvis will be: $30 x 0.8 + $24.65 x 0.9 = $46.185 million

Mary Contrary is offered a $1,600 loan for a year to be paid back in equal quarterly principal installments of $400 each. If Mary is offered the loan at 6 percent simple interest, how much in total interest charges will she pay? Would Mary be better off (in terms of lower interest cost) if she were offered the $1,600 at 5 percent simple interest with only one principal payment when the loan reaches maturity? What advantage would this second set of loan terms have over the first set of loan terms?

If the principal of $400 is repaid every quarter, Mary will pay the following in interest on her $1600 loan for one year at 6 percent simple interest: First Quarter: I = 1,600 x 0.06 x 0.25 = $24 Second Quarter: I = 1,200 x 0.06 x 0.25 = $18 Third Quarter: I = 800 x 0.06 x 0.25 = $12 Fourth Quarter: I = 400 x 0.06 x 0.25 = $6 Therefore, total Interest owed = $60 However, if she was offered the $1,600 loan at a 5 percent simple interest rate and the loan is repaid in lump sum at maturity, she will end up paying a total interest of:$80 ($1,600 × 0.05). Therefore, purely from an interest cost point of view, Mary is better off borrowing using the first option. However, in the second option she would have the full amount of $1,600 available for use for one year.

Why do interest rates on consumer loans typically average higher than on most other kinds of loans?

Interest rates on consumer loans are typically higher than on most other kinds of loans since they are among the most costly as well as risky to make per dollar of loanable funds committed. Consumer loans also tend to be cyclically sensitive. Moreover, demand for consumers loans tend to be relatively inelastic to changes in interest rates.

What advantages do commercial banks with investment banking affiliates appear to have over competitors that do not offer investment banking services? Possible disadvantages?

Investment banking services complement traditional lending services allowing commercial banking firms to offer both conventional loans and security underwriting to customers who seek to raise new funds. In addition, there are economies of scale in information gathering about clients. Though the benefits of cost and risk reduction through this new service dimension have not been proven, the commercial banks have transformed investment banking industry by acquiring some of its largest firms and consolidating smaller investment banks into larger ones. However, investment banking services are highly sensitive to fluctuations in the economy and would increase the risk exposure of the commercial bank.

What are investment products? What advantages might they bring to an institution choosing to offer these services?

Investment products include stocks, bonds, mutual funds, annuities, and other nondeposit services. The most popular investment products offered by depository institutions include mutual funds. The potential advantages of offering these services to customers include generating considerable fee income which may be less sensitive to interest rate movements than traditional services such as loans and deposits. In addition, it is possible that it might add prestige and may help position the institution well for the future as more and more individuals start planning for retirement.

What sources of information are available today that loan officers and credit analysts can use in evaluating a customer loan application?

Lending institutions, nowadays, have access to multiple sources of information that they can use to evaluate a loan application from a customer. For corporates, financial statements supplied by the borrower, ratings provided by credit rating agencies, and industry-wide performance ratios for comparison purposes supplied by such organizations as Dun and Bradstreet and Risk Management Associates (RMA) are widely used. For individuals, a lender can contact the one of the various credit bureaus to find out a customer's credit history of a customer. The lending institution may also contact other lenders to determine their experience with the borrowing customer.

What is loan review? How should a loan review be conducted?

Loan review is a process of periodic review of outstanding loans on an institution's books to make sure each loan is paying out as planned, all necessary documentation is present, and the bank's loan officers are following the institution's loan policy. It also involves regularly reviewing a borrower's financial health which may change as a result of change in economic variables. The exercise helps senior management and the bank's board of directors in assessing the overall exposure to risk and its possible need for more capital in the future. While lending institutions today use a variety of different loan review procedures, few general procedures that are followed by nearly all lending institutions include: 1. Carrying out reviews of all types of loans on a periodic basis 2. Structuring the loan review process carefully to make sure the most important features of each loan are checked 3. Reviewing the largest loans most frequently 4. Conducting more frequent reviews of troubled loans 5. Accelerating the loan review schedule if the economy slows down or if industries in which the bank has made a substantial portion of its loans develop significant problems

What are some warning signs to management that a problem loan may be developing?

Loans characterized by reduced communication between borrower and lender, delays in receiving financial reports, evidence of revaluations of assets (such as inventory or pension-plan assets), declining stock prices, changes in management, consistently declining profits, change in credit rating, or restructuring of other loans the borrower has taken out are often considered as indications of a developing problem loan.

What is home equity lending, and what are its advantages and disadvantages for banks and other consumer lending institutions?

Loans involving a borrowing base of the residual market value of a home (value over and above the amount of any outstanding liens against the home), being drawn upon as collateral is known as home equity lending. Borrowers can secure home equity loans for second mortgage, college tuition, or any other financial needs that they may have. Usually these loans carry a lower rate of interest than consumer loans. It is advantageous for the lending institutions since these loans are secured against the equity value of the property. However, these loans are made on the premise that housing prices will not fall significantly. This may not always be a correct assumption. If the housing market slows down and property prices decline, the borrower may default. The banks will likely be forced to foreclose in such situations. It may also face difficulty in selling the property in an already depressed market. Also, there is always a risk of the bank's reputation being harmed in the event of foreclosures. Moreover, regulations prohibit the lending institutions from arbitrarily cancelling any home equity loans.

In order to help fund a loan request of $10 million for one year from one of its best customers, Lone Star Bank sold negotiable CDs to its business customers in the amount of $6 million at a promised annual yield of 2.75 percent and borrowed $4 million in the Federal funds market from other banks at today's prevailing interest rate of 2.80 percent. Credit investigation and recordkeeping costs to process this loan application were an estimated $25,000. The Credit Analysis Division recommends a minimal 1 percent risk premium on this loan and a minimal profit margin of one-fourth of a percentage point. The bank prefers using cost-plus loan pricing in these cases. What loan rate should it charge?

Lone Star Bank has sold negotiable CDs in the amount of $6 million at a yield of 2.75 percent and purchased $4 million in Federal funds at a rate of 2.80 percent. The weighted average cost of bank funds in this case would be: We can find the interest cost of funding a $10 million loan as follows: Sale of negotiable CDs cost $165,000 ($6,000,000 × 2.75 percent) to the bank. Whereas, the funds borrowed from Federal funds cost $112,000 ($4,000,000 × 2.80 percent). Hence, the total interest cost of $277,000 is to be borne by the bank. On a $10 million loan, t average annual interest cost is 2.77 percent ($277,000 ÷ $10,000,000). The bank incurs a noninterest cost 0.25 percent ($25,000 ÷ $10,000,000) to process this loan application. The bank considers a risk premium one percent and a 0.25 percent minimal profit margin. Based on the cost-plus loan pricing model: Loan interest rate = Marginal cost of raising loanable funds to lend to the borrower + Nonfunds operating costs + Estimated margin to compensate for default risk + Desired profit margin Loan interest rate = 2.77% + .25% + 1% + .25% = 4.27%

Why are there so many mergers each year in the financial-services industries?

Many mergers and acquisitions have happened in the entire financial-service sector in recent years. Many of these mergers have occurred because of lower legal barriers that previously prohibited or restricted expansion. With several acts like Riegle-Neal Interstate Banking Act of 1994 and Gramm-Leach-Bliley (GLB) Act of 1999 being passed, mergers in financial services received a legislative boost. This convergence and consolidation trend has brought banks into common ownership with security and commodity broker-dealer firms, finance companies, insurance agencies and underwriters, credit card companies, thrift institutions, and numerous other nonbank service providers.

Greg Lance has just been informed by a finance company that he can access a line of credit of no more than $75,000 based upon the equity value in his home. Lance still owes $180,000 on a first mortgage against his home and $25,000 on a second mortgage against the home, which was incurred last year to repair the roof and driveway. If the appraised value of Lance's residence is $400,000, what percentage of the home's estimated market value is the lender using to determine Lance's maximum available line of credit?

Maximum credit line can be calculated as: (Appraised Value x Allowable Percentage of Market Value) - Mortgage Loans Outstanding OR Allowable % of Market Value = (Max Credit Line + Mortgage Loans Outstanding) / Appraised Value Therefore, Allowable % of Market Value = ($75,000 + $25,000 + $180,000) / $400,000 = 70% The lender is using approximately 70% of market value of Greg's home to determine his available credit line.

Operating Efficiency Ratios

Measure of a business firm's performance effectiveness 1. Annual COGS / Average Inventory 2. Net Sales / Net Fixed Assets 3. Net Sales / Total Assets 4. Net Sales / Accounts and Notes Receivable 5. Average Collection Period = Accounts Receivable / (Annual Credit Sales / 30)

Exactly what is a merger?v

Mergers simply mean the financial transactions that result in acquisition of one or more firms by another institution. Here, the acquired firm (usually the smaller of the two) gives up its charter and adopts a new name (usually the name of the acquiring organization). The assets and liabilities of the acquired firm are added to those of the acquiring institution. To affect a proposed merger, the board of directors must ratify the same. This can be possibly done when shareholders of all the parties involved approve the merger transaction once it is negotiated among the management of the parties to the merger. Once the shareholders of each firm involved give approval to the merger, approval must then be sought from the Department of Justice and the principal federal regulatory agency of each firm in the merger.

What options does a loan officer have in pricing consumer loans?

Most consumer loans, like most business loans, are priced off some base or cost rate, with a profit margin and compensation for risk added on. This is known as cost plus model. Some of the other pricing mechanisms followed in pricing a consumer loans are: Annual percentage rate: The annual percentage rate is the internal rate of return (annualized) that equates expected total payments for the lender with the amount of the loan. Simple interest: This method computes the repayment amount by adding a flat rate of interest to the borrowed amount adjusted for the length of time of borrowing. The discount rate method: This method requires the customer to pay interest up front. Under this approach, interest is deducted upfront and the customer receives the loan amount less any interest owed. The add-on rate method: This method of pricing involves adding up the entire interest cost to the principal amount upfront before determining the instalments for the borrower. Rule of 78s: This method determines the amount of interest income a lender is entitled to accrue at any point in time from a loan that is being paid out in monthly installments. Most installments and lump-sum payment loans are made with fixed interest rates. However, due to increasing volatility in interest rates a large number of floating rate consumer loans have also gained popularity.

Does it appear that most mergers serve the public interest?

Most studies that have looked at this issue find few real public benefits. In fact, about one-third banks changed their pricing policies. The most common change was a price increase following a merger, particularly in checking account service fees, loan rates, deposit interest rates, and safe-deposit box fees. On the positive side, there is no convincing evidence that the public has suffered a decline in service quality or availability following most bank mergers. Moreover, mergers may significantly lower the bank failure rate. Crossing state lines seems to be somewhat effective in helping to stabilize asset and equity returns, reducing the chances of insolvency and resulting in lower operating costs. However, some smaller businesses may suffer a bit if their principal bank is acquired and they don't yet have a relationship with the new owners. Mergers and acquisitions do tend to stimulate market entry of new competitors. This situation can have multiple outcomes as some customers quickly look around for new service providers or can also lead to cost cutting including firing some employees who then start up new financial firms to challenge their former employers. Hence, mergers and acquisitions usually generate a mixture of winners and losers.

What are points? What is their function?

Often, home loan borrowers are required to pay an additional charge upfront called points. Each point is equivalent to one percentage point. Total amount needed to be paid by the borrower equals these points multiplied by the mortgage amount. Usually these extra charges are levied by a lending institution to be able to earn a higher effective interest rate.

In what ways is a real estate loan unique compared to other kinds of bank loans?

Real estate loans differ from any other kind of loan in several aspects. The average size of a mortgage loan is usually much higher than that of any other loan. Also, the duration of these loans tends to be much longer, typically between 15 to 30 years. Both these factors also significantly increase the associated risks—including adverse changes in economic conditions, interest rates, value of the collateral, and the health of the borrower—for a lending institution.

What challenges have U.S. bankruptcy laws provided for consumers and those lending money to them?

Recent changes in U.S. bankruptcy laws present serious challenges to consumer lending institutions. Congress passed the Bankruptcy Reform Act in 1978, amending a federal bankruptcy code that had stood since the turn of the century. While amendments in 1984 tightened up some of the loopholes in the 1978 law, the most recent reforms tipped the legal scales substantially in favor of individuals filing bankruptcy petitions and more severely limited the amount and kinds of debtors' assets that could be converted into cash for distribution to banks and other creditors. However, the Bankruptcy Abuse Prevention and Consumer Protection Act was signed in April of 2005. This law is likely to make it more difficult, expensive and time consuming to file for bankruptcy. Consumers must complete a credit counseling program before becoming eligible for filing bankruptcy. Also, a 'means test' must be undertaken by consumers to determine whether they are eligible to file for Chapter 7 bankruptcy—which wipes out most debt—or whether they will have to file Chapter 13—which requires them to have a court approved repayment plan for their outstanding debt. Overall, the revised bankruptcy code is expected to eventually reduce the cost of credit for the average borrower because it may tend to reduce the incidence of bad loans. For the banks though, it may result in slow growth of credit card and instalment loans as consumers become more cautious about running up too much debt and shift more of their borrowing into housing-related loans because a bankrupt's home (depending on the laws in the borrower's home state) may be protected from seizure by creditors.

What are the principal differences among residential loans, nonresidential installment loans, noninstallment loans, and credit card or revolving loans?

Residential loans are credit to finance the purchase of a home or fund improvements on a private residence. Nonresidential loans to individuals and families include installment loans and noninstallment loans. Short-term to medium-term loans, repayable in two or more consecutive payments (usually monthly or quarterly), are known as installment loans. Installment loans are paid off gradually over time, whereas short-term loans that individuals and families draw upon for immediate cash needs and are repayable in a lump sum at the end of the loan are known as noninstallment loans. Installment loans usually finance large-ticket purchases, such as automobiles or household furniture, whereas noninstallment loans usually are directed at current living expenses. Installment loans help the bank recover funds that can be reloaned more quickly but they generally require a more intensive credit investigation by the bank. Bank credit cards offer convenience and a revolving line of credit that customers can access whenever the need arises.

What factors should a lender consider in evaluating real estate loan applications?

Some of the important factors to be considered in evaluating a real estate loan application are: 1. The amount of down payment planned by the borrower as a percentage of the purchase price of the property—a critical factor in determining the safety level for a lending institution. 2. Potential future business that can be gained as a result of providing a mortgage loan. 3. Amount and stability of the borrower's income—a determinant of the borrower's capacity to service the debt as and when it becomes due. 4. The outlook for real estate sales in the local market area. 5. The outlook for interest rates in the economy

What legal protections are available today to protect borrowers against discrimination? Against predatory lending?

The Equal Credit Opportunity Act outlaws discrimination in lending based on race, age, sex, religious preference, receipt of public assistance, or any other irrelevant factors. The Community Reinvestment Act requires banks and other lending institutions to make an affirmative effort to serve all segments of their designated market areas without discriminating against certain neighborhoods. Predatory lending is an abusive practice among some lenders that involves making loans to borrowers with below-average credit rating and then charging them excessive fees and interest rates, thereby increasing the risk of default. In 1994 Congress passed the Home Ownership and Equity Protection Act, which was aimed to protect home owners from loan agreements they could not afford. Loans with annual percentage rates (APR) of 10 percentage points or more above the yield on comparable maturity U.S. Treasury securities and closing fees above 8 percent of the loan amount are defined as "abusive." Consumers have 6 days (three days before plus three days after a home loan closing) in which to decide whether or not to proceed with the loan. Also, credit granting institutions must fully disclose all fees, risks and prohibitory conditions associated with the loan, failing which, a borrower has up to 3 years to rescind the transaction, and lenders might be liable for all damages that occur.

Why were U.S. commercial banks forbidden to offer investment banking services for several decades? How did this affect the ability of U.S. banks to compete for underwriting business?

The Glass-Steagall Act in 1933 prohibited commercial banks from offering investment bank services for primary two reasons. One, the bank could force a customer seeking a loan to buy the securities that they were trying to sell as a condition for getting a loan, and second, the bank would be exposed to increased risk due to the volatile and cyclical behavior of investment banking activities. Due to this, U.S banks were not able to compete for underwriting business with foreign banking firms who in turn captured U.S. customers.

When is a market too concentrated to allow a merger to proceed? What could happen if a merger were approved in an excessively concentrated market area?

The Justice Department guidelines require calculation of the Herfindahl-Hirschman Index (HHI) as a summary measure of market concentration. HHI reflects the proportion of assets, deposits, or sales accounted for by each firm serving a given market. HHI may vary from 10,000 (i.e., 1002)—a monopoly position, where the leading firm is the market's sole supplier—to near zero for unconcentrated markets. As per the Department of Justice guidelines established in 1997, the Federal Reserve merger policy states that the market area is too concentrated to allow a merger, if the postmerger HHI increases 200 or more points to a level of 1,800 or more or if the postmerger market share rises to 35 percent or more. If the Justice Department decides that the resultant merger will make the banking market too concentrated they are likely to challenge the merger in federal court. However, merger combinations exceeding these standards often require mitigating factors (such as greater likelihood of future market entry) in order to gain Federal Reserve approval.

Suppose a customer is offered a loan at a discount rate of 8 percent and pays $75 in interest at the beginning of the term of the loan. What net amount of credit did this customer receive? Suppose you are told that the effective rate on this loan is 12 percent. What is the average loan amount the customer has available during the year?

The amount of net credit received by the customer will be: $75 / 8% = $937.5 An effective rate of 12 percent implies an interest cost of 12 percent on the available funds to the borrower. Since the interest paid is $75, the average funds available will be: $75 / 12% = $625

A lender's cost accounting system reveals that its losses on real estate loans average 0.45 percent of loan volume and its operating expenses from making these loans average 1.85 percent of loan volume. If the gross yield on real estate loans is currently 8.80 percent, what is this lender's net yield on these loans?

The bank's net yield on real estate loans is gross yield as reduced by costs associated with the loans: Therefore, net yield on real estate loans will be:

James Smithern has asked for a $3,500 loan from Beard Center National Bank to repay some personal expenses. The bank uses a credit-scoring system to evaluate such requests, which contains the following discriminating factors along with their associated point weights in parentheses: Credit Rating (excellent 3; average 2; poor or no record 0) Time in Current Job (five years or more, 6; one to five years, 3) Time at Current Residence (more than 2 years, 4; one to two years, 2; less than one year, 1) Telephone in Residence (yes, 1; no, 0) Holds Account at Bank (yes, 2; no, 0) The bank generally grants a loan if a customer scores 9 or more points. Mr. Smithern has an average credit rating, has been in his current job for three years and at his current residence for two years, has a telephone, but has no account at the bank. Is James Smithern likely to receive the loan he has requested?

The credit score for Mr. Smithem can be calculated as follows: Credit rating: average 2 points Time in current job: one to five years 3 points Time in current residence: one to two years 2 points Telephone: Yes 1 point Holds Bank Account: No 0 points Mr. Smithern's total credit score is 8. Given, the bank grants loans to applicants with credit scores of 9 or more points, Mr. Smithern is not likely to receive a loan under this scoring system.

What are the principal advantages to a lending institution of using a credit-scoring system?

The credit scoring method has the advantage of being objective, requiring less loan officer judgment, possibly reducing loan losses, reducing operating costs, and quicker evaluation of applications when a large volume of consumer loans is being processed.

What factors must the regulatory authorities consider when deciding whether to approve or deny a merger?

The federal supervisory agencies prefer to approve mergers that will enhance the financial strength of the institutions involved as they encourage the need for improving management skills and strengthening equity capital. Under the terms of the Bank Merger Act, each federal agency must give top priority to the competitive effects of a proposed merger. This means estimating the probable effects of a merger on the pricing and availability of financial services in the local community and on the degree of concentration of deposits or assets in the largest financial institutions in the local market. Mergers that would significantly damage competition cannot be approved unless there are mitigating instigating circumstances (e.g., one of the firms involved is failing). Public convenience must also be weighed by the regulatory agencies to determine if the merger would improve the supply of needed services that are perhaps currently not being conveniently and efficiently provided to the public. Along with these, the other factors that must be weighed to approve a merger include the financial history and condition of the merging institutions, the adequacy of their capital, their earnings prospects, strength of management, and the convenience and needs of the community to be served.

Suppose a business borrower projects that it will experience net profits of $2.1 million, compared to $2.7 million the previous year, and will record depreciation and other noncash expenses of $0.7 million this year versus $0.6 million last year. What is this firm's projected cash flow for this year? Is the firm's cash flow rising or falling? What are the implications for a lending institution thinking of loaning money to this firm? Suppose sales revenue rises by $0.5 million, cost of goods sold decreases by $0.3 million, while cash tax payments increase by $0.1 million and noncash expenses decrease by $0.2 million. What happens to the firm's cash flow? What would be the lender's likely reaction to these events? (Note: Assume the noncash expense is already included in the cost of goods sold.)

The firm's projected cash flow can be estimated by adding non-cash expenses (depreciation) to its net income. Cash flow of the firm in the previous year: 2.7 + 0.6 = 3.3 million. Expected cash flows in the current year: 2.1 + 0.7 = 2.8 million. Clearly the firm's cash flow is falling. The lending institution needs to find out the reasons for this decline before committing any funds. Under the new scenario, the implications for the cash flows would be: Sales revenue $0.50 Costs of goods sold 0.30 Cash tax payments -0.10 Noncash expenses -0.20 Total $0.70 Since the cash flows for the firm have risen by $0.5 million, it should be more comforting for the lender to loan out funds to the borrower.

What laws exist today to give consumers fuller disclosure about the terms and risks of taking on credit?

The following federal laws give consumers who are borrowing money fuller disclosure about the terms and risks of taking on credit: a. Truth-in-Lending Act, 1968 b. Fair Credit Reporting Act c. Fair Credit Billing Act, 1974 d. Fair Credit and Charge-Card Disclosure Act e. Fair Debt Collection Practices Act The Truth-in-Lending Act mandates that lenders must provide their customers with information on all loan charges and associated risks in a disclosure statement. The Fair Credit Reporting Act gives individuals easier access to their credit-bureau records, the right to challenge information contained therein, and to insist on the prompt correction of errors. The Fair Credit Billing Act gives consumers the right to dispute billing errors and have those errors corrected. The Fair Credit and Charge-Card Disclosure requires that customers applying for credit cards be given early written notice (usually before a credit card is used for the first time) about required fees to open or renew a credit account. Also, if a fee for renewal is charged, the customer must receive written notice in advance. The Fair Debt Collection Practices Act limits how far a creditor or credit collection agency can go in pressing that customer to pay up.

What methods are used to price business loans?

The following methods are in use today to price business loans: a. Cost-plus loan pricing b. Price leadership pricing model c. Below-prime market pricing d. Customer profitability analysis (CPA) Cost-plus-profit pricing requires the bank to add the cost of raising adequate funds to lend, the lender's nonfunds operating costs, compensation for the degree of default risk inherent in a loan request, and the desired profit margin. The price-leadership model, on the other hand, bases the loan rate upon a uniform national or international rate (such as prime or LIBOR) posted by major commercial banks. The prime rate is usually considered to be the lowest rate charged to the most creditworthy customers on short-term loans. The actual loan rate charged to any particular customer is determined by adding the default-risk premium and the term-risk premium as a markup over the prime rate. Lending institutions can expand or contract their loan portfolios simply by contracting or expanding their loan-rate markups. The below-prime market pricing prices a loan on the basis of cost of borrowing in the money market plus a small profit margin. Customer profitability analysis looks at all the revenues and costs involved in serving a customer and then the bank is required to calculate the net rate of return from some large corporates covering a loan for only a few days or weeks.

What three major questions or issues must a lender consider in evaluating nearly all loan requests?

The key issues that a lender must consider while evaluating any loan request are: 1. Is the borrower creditworthy? 2. Can the loan agreement be properly structured and documented? 3. Can the lender perfect its claim against the borrower's earnings and any assets that may be pledged as collateral?

Mr. and Mrs. Napper are interested in funding their children's college education by taking out a home equity loan in the amount of $24,000. Eldridge National Bank is willing to extend a loan, using the Nappers' home as collateral. Their home has been appraised at $110,000, and Eldridge permits a customer to use no more than 70 percent of the appraised value of a home as a borrowing base. The Nappers still owe $60,000 on the first mortgage against their home. Is there enough residual value left in the Nappers' home to support their loan request? How could the lender help them meet their credit needs?

The maximum credit line available to the Nappers under the bank's current home-equity loan policy is: ($110,000 x 70%) - $60,000 = $17,000 This clearly is not a large enough borrowing base to cover the $24,000 loan requested. Many banks make adjustments in the permissible loan amount if the customer has an above-average level of income, other assets to pledge, relatively low mortgage debt obligations, and an excellent credit rating. Thus, the Nappers may be able to qualify for an additional $7,000 in loanable funds (perhaps by pledging other collateral) to make up the $24,000 they need.

What are the principal parts of a loan agreement? What is each part designed to do?

The most important parts of loan agreements include a promissory note, a loan commitment agreement, collateral, covenants, and a section listing events of default. A promissory note states the principal amount, the interest rate, and the terms of the loan. A loan commitment agreement is a document in which the lender promises to make the loan available to the borrower over a designated future period up to a maximum amount in return for a commitment fee. Covenants specify what the borrower must and must not do. Collateral refers to the assets pledged by the borrower to protect the lender's interests. A listing of events of default states the actions that the lender of the loan is legally authorized to take in order to secure the funds in the event of default by the borrower.

What factors appear to influence the growth and mix of loans held by a lending institution?

The particular mix of any lending institution's loan portfolio is shaped by the characteristics of its market area, the expected yield and cost associated with each type of loan, loan participations, size of the lending institution, experience and expertise of the management, the institution's written loan policy, expected yields, and regulations.

What services are provided by investment banks (IBs)? Who are their principal clients?

The primary role of investment bankers is to serve as financial advisers to corporations, governments, and other large institutions. Investment banks help underwrite a number of securities for corporations including common and preferred stock, corporate bonds, government and federal agency securities and others. In addition, they can provide a number of services including advising clients regarding acquisitions and mergers, creating and trading in derivatives, brokering loan sales, setting up special-purpose entities, stock and bond trading, currency and commodity trading, issuing credit and liquidity enhancements and developing business plans so companies can expand into new markets.

What aspect of a business firm's operations is reflected in its ratio of cost of goods sold to net sales? In its ratio of net sales to total assets? In its GPM ratio? In its ratio of income before interest and taxes to total interest payments? In its acid-test ratio? In its ratio of before-tax net income to net worth? In its ratio of total liabilities to net sales? What are the principal limitations of these ratios?

The ratio of cost of goods sold to net sales is a widely used indicator of a business firm's expense controls. The ratio of net sales to total assets reflects the operating efficiency indicating the efficiency with which the assets are being utilized to generate sales. The gross profit margin (GPM) measure reflects the marketability of the customer's products or services. A firm's ratio of income before interest expense and taxes to total interest payments indicates how effectively a business is covering its interest expenses through the generation of before-tax income. The acid-test ratio provides a rough measure of a firm's liquidity position The ratio of before-tax income to net worth represents a measure of profitability of the business. Finally, the ratio of liabilities to net sales is an indicator of management's use of financial leverage. These ratios are affected by changes in the numerator or the denominator or both; a financial or credit analyst would want to know the source of any change in a ratio's value. These ratios only measure problem symptoms; you must dig deeper to find the cause.

What is cash-flow analysis, and what can it tell us about a business borrower's financial condition and prospects?

The statement of cash flows shows how cash receipts and disbursements are generated by operating, investing, and financing activities of a business firm. Such a cash flow statement indicates the changes in a business firm's assets and liabilities as well as its flow of net profit and noncash expenses (such as depreciation) over a specific time period. It shows where the firm raised its operating capital during the time period under examination and how it spent or used those funds in acquiring assets or paying down liabilities. It also examines all purchases and sales of securities and long-term assets, such as plant and equipment in the form of investing activity. The financing activities section of the firm will include cash flows from short- and long-term funds provided by lenders and owners, while cash outflows will include the repayment of borrowed funds, dividends to owners, and the repurchasing of outstanding stock. From the perspective of a loan officer, the cash flow statement indicates whether the firm is relying heavily upon borrowed funds or on sales of assets. These are two less desirable funding sources from the point of view of lending money to a business firm as these sources of cash inflow suggest the company may be exhausting its liquidity and capacity to borrow, casting doubts regarding its ability to repay future borrowings. Loan officers usually prefer to focus upon the generation of sufficient cash flows to repay most of its debt and remain viable in the long run.

Yorktown Savings Bank, in reviewing its credit card customers, finds that of those customers who scored 40 points or less on its credit-scoring system, 30 percent (or a total of 7,665 credit customers) turned out to be delinquent credits, resulting in total loss. This group of bad credit card loans averaged $6,200 in size per customer account. Examining its successful credit accounts Yorktown finds that 12 percent of its good customers (or a total of 3,066 customers) scored 40 points or less on the bank's scoring system. These low-scoring but good accounts generated about $1,000 in revenues each. If Yorktown's credit card division follows the decision rule of granting credit cards only to those customers scoring more than 40 points and future credit accounts generate about the same average revenues and losses, about how much can the bank expect to save in net losses?

The total loss to the bank from delinquent customers is ($47,523,000 ($6,200 × 7,665). On the other hand, paying credit-card customers (amounting to 3,066 customers) averaged a score of 40 points or less, but successfully generated about $1,000 a piece in revenues, resulting in aggregate revenues of $3,066,000. By adopting a decision rule to grant credit-card privileges only to customers scoring more than 40 points (and given the same average revenues and losses) the bank will save $44,457,000 ($47,523,000 - $3,066,000) in net losses.

What risks do investment products pose for the institutions that sell them? How might these risks be minimized?

There are several risks involved in the sale of investment products. The value of these products is market driven and customers may blame the bank when they do not reach their earnings goals. Because of their reputation, customers may hold depository institutions to a higher standard than securities brokers for example. As a result, they may end up getting involved in costly litigation with customers who are disappointed or who claim that the risks involved were not adequately explained. In addition, they may have compliance problems if they do not properly register their investment products with the Securities Exchange Commission or fail to follow the rules laid down by regulatory agencies, state commissions, and other legal bodies that monitor this market for the sale of these products. Regulators already require these products to be sold in a separate area from where deposits are taken and banks are required to prominently display that these products are not insured by the Federal Deposit Insurance Corporation. The customers should also be informed that the investment products are not a deposit or other obligation of a depository institution and not guaranteed by the offering institution. In addition, customers must be told that these products are subject to risks, including potential loss of principal. Customers must sign a document stating they were informed of these risks. The institutions must make sure that the names of these products cannot be confused with their regular products. Finally, they must demonstrate that they are regularly monitoring themselves to ensure that their sales personnel are complying with the regulatory requirements and banks are also supposed to be sure that the products they sell meet the needs of each particular customer and situation. Compliance with these regulations should help minimize the risks inherent in these products.

How do trust services generate fee income and often deposits as well for banks and other financial institutions offering this service?

Trust departments manage the assets of their customers. The financial institution charges their customers a fee for providing these services and generates fee income. Assets managed by the trust departments include deposits and, in some cases, these deposits can be substantial. This way, trust departments often generate large deposits because they manage property for their customers. It is worth noting that deposits placed in a bank by a trust department must be fully secured.

What exactly are trust services?

Trust departments manage the property of customers including their securities, land, buildings and other investments. This is one of the oldest services provided by banks. Trust departments should safeguard and prudently manage a customer's assets to generate earnings.

What special problems does business lending present to the management of a business lending institution?

While business loans are usually considered among the safest types of lending (their default rate, for example, is usually well below default rates on most other types of loans), these loans average much larger in dollar volume than other loans and, therefore, can subject an institution to excessive risk of loss and, if a substantial number of loans fail, can lead to failure. Moreover, business loans are usually much more complex financial deals than most other kinds of loans, requiring larger numbers of personnel with special skills and knowledge. These additional resources required an increase in the magnitude of potential losses unless the business loan portfolio is managed with great care and skill.

What steps should a lender go through in trying to resolve a problem loan situation?

While workout of each problem loan may depend on the circumstances due to which the loan has turned underperformer, some of the common steps involved include: 1. The goal of all loan workouts should be to maximize the chances of recovery of funds. 2. Problems with any loans should be quickly detected and reported. 3. Loan workout process should be independent of the lending function to avoid any conflict of interest. 4. Loan workout specialists should conduct a preliminary analysis of the problem and its possible causes and confer with the troubled customer quickly on the possible options, including any financial and operational restructuring. 5. A preliminary plan of action should be developed after determining the risk exposure, sufficiency of loan documents, and estimated liquidation values of assets and deposits. 6. Loan workout personnel should conduct a tax and litigation search to check for any other unpaid liabilities of the borrower. For business borrowers, loan personnel must evaluate the quality, competence, and integrity of current management. 7. Loan workout professionals must consider all reasonable alternatives for cleaning up the troubled loan including an option to seek a revised loan agreement.

Explain the following terms: character, capacity, cash, collateral, conditions, and control.

a. Character - Character assessment involves finding out the purpose of credit request by a customer and the intention of the borrower to repay the funds. b. Capacity - Capacity is a customer's authority to request a loan and the legal standing to sign a binding loan agreement. c. Cash - Cash is the ability of a customer to generate sufficient cash flows to service the principal and interest amount on the loan as and when they become due. d. Collateral - Collateral refers to an asset pledged by a borrower as a security with the lending institution against loaned funds. e. Conditions - Conditions refer to the current economic situations in the borrower's line of work. This is important because the ability of the borrower to generate cash flows may be affected by change in conditions. f. Control - The control element refers to considerations regarding the impact of changes in law and regulation that can adversely affect the borrower and whether the loan request meets the lender's and the regulatory authorities' standards for loan quality.

Under which of the six Cs of credit discussed in this chapter does each of the following pieces of information belong? The particular C of credit represented by each piece of information presented in this problem was as follows: a. First National Bank discovers there is already a lien against the fixed assets of one of its customers asking for a loan. b. Xron Corporation has asked for a type of loan its lender normally refuses to make. c. John Selman has an excellent credit rating. d. Smithe Manufacturing Company has achieved higher earnings each year for the past six years. e. Consumers Savings Association's auto loan officer asks a prospective customer, Harold Ikels, for his driver's license. f. Merchants Center National Bank is concerned about extending a loan for another year to Corrin Motors because a recession is predicted in the economy. g. Wes Velman needs an immediate cash loan and has gotten his brother, Charles, to volunteer to cosign the note should the loan be approved. h. ABC Finance Company checks out Mary Earl's estimate of her monthly take-home pay with Mary's employer, Bryan Sims Doors and Windows. i. Hillsoro Bank and Trust would like to make a loan to Pen-Tab Oil and Gas Company but fears a long-term decline in oil and gas prices. j. First State Bank of Jackson seeks the opinion of an expert on the economic outlook in Mexico before granting a loan to a Mexican manufacturer of auto parts. k. The history of Membres Manufacture and Distributing Company indicates the firm has been through several recent changes of ownership and there has been a substantial shift in its principal suppliers and customers in recent years. l. Home and Office Savings Bank has decided to review the insurance coverages maintained by its borrowing customer, Plainsman Wholesale Distributors.

a. Collateral b. Control c. Character d. Cash e. Capacity f. Conditions g. Character h. Cash i. Conditions j. Control k. Capacity l. Collateral

What term in the consumer lending field does each of the following statements describe? a. Plastic card used to pay for goods and services without borrowing money b. Loan to purchase an automobile and pay it off monthly c. If you fail to pay the lender seizes your deposit d. Numerical rating describing likelihood of loan repayment e. Loans extended to low-credit-rated borrowers f. Loan based on spread between a home's market value and its mortgage balance g. Method for calculating rebate borrower receives from retiring a loan early h. Lender requires excessive insurance fees on a new loan i. Loan rate lenders must quote under the Truth in Lending Act j. Upfront payment required as a condition for getting a home loan

a. Debit card b. Installment loan c. Right of offset d. Credit score e. Subprime loans f. Home equity loans g. Rule of 78s h. Predatory lending i. APR j. points

From the descriptions below please identify what type of business loan is involved. a. A temporary credit supports construction of homes, apartments, office buildings, and other permanent structures. b. A loan is made to an automobile dealer to support the shipment of new cars. c. Credit extended on the basis of a business's accounts receivable. d. The term of an inventory loan is being set to match the length of time needed to generate cash to repay the loan. e. Credit extended up to one year to purchase raw materials and cover a seasonal need for cash. f. A securities dealer requires credit to add new government bonds to his securities portfolio. g. Credit granted for more than a year to support purchases of plant and equipment. h. A group of investors wishes to take over a firm using mainly debt financing. i. A business firm receives a three-year line of credit against which it can borrow, repay, and borrow again if necessary during the loan's term. j. Credit extended to support the construction of a toll road.

a. Interim construction financing b. Retailer and equipment financing c. Asset-based financing d. Self-liquidating inventory loan e. Working capital loan f. Security dealer financing g. Term business loan h. Acquisition loan or leveraged buyout i. Revolving credit financing j. Long-term project loan

Identify which of the following loan covenants are affirmative and which are negative covenants: a. Nige Trading Corporation must pay no dividends to its shareholders above $3 per share without express lender approval. b. HoneySmith Company pledges to fully insure its production line equipment against loss due to fire, theft, or adverse weather. c. Soft-Tech Industries cannot take on new debt without notifying its principal lending institution first. d. PennCost Manufacturing must file comprehensive financial statements each month with its principal bank. e. Dolbe King Company must secure lender approval prior to increasing its stock of fixed assets. f. Crestwin Service Industries must keep a minimum current (liquidity) ratio of 1.5× under the terms of its loan agreement. g. Dew Dairy Products is considering approaching Selwin Farm Transport Company about a possible merger but must first receive lender approval.

a. The stipulation that prior bank approval of a proposed merger must be obtained is a negative loan covenant.a. Restrictions on payment of dividends represent negative loan covenants. b. A requirement to insure selected assets is an affirmative loan covenant. c. Restrictions against taking on new debt represent negative loan covenants. d. The requirement of filing periodic financial statements with the bank is an affirmative loan covenant. e. A requirement of securing bank approval before adding to a borrower's stock of fixed assets is considered a negative loan covenant. f. Requiring a borrowing customer to maintain a current ratio—a liquidity measure—no lower than 1 .5× is an affirmative loan covenant. g. The stipulation that prior bank approval of a proposed merger must be obtained is a negative loan covenant.

Based on what you learned from reading this chapter and from studies you uncovered on the Web, which of the financial firms listed below are most likely to benefit from economies of scale or scope and which will probably not benefit significantly from these economies based on the information given? a. A new bank offering traditional banking services (principally deposits and loans) was chartered earlier this year, gaining $50 million in assets within the first six months. b. A community bank with about $250 million in assets provides traditional banking services but also operates a small trust department for the convenience of families and small businesses. c. A financial holding company (FHC) with about $2 billion in assets offers a full range of banking and investment services, giving customers access to a family of mutual funds. d. A bank holding company with just over $10 billion in assets also operates a security brokerage subsidiary, trading in stocks and bonds for its customers. e. A financial holding company (FHC) with $750 billion in assets controls a commercial bank, investment banking house, chain of insurance agency offices, and finance company and supplies commercial and consumer trust services through its recently expanded trust department.

a. This bank should benefit from the increase in size as economies of scale take effect. This firm should continue to enjoy economies of scale as it grows in the next several years. However, these economies of scale will not continue indefinitely and there is some evidence that economies of scale are exhausted fairly quickly in banking firms. The bank could benefit from economies of scope if it has resources that could be used to produce different services. b. This bank probably does not benefit much from economies of scope. It is possible that the bank uses the same resources to provide both traditional banks services and trust services, in which case it could benefit from economies of scope. c. Economies of scale start to disappear in about this range although there may be some small economies of scale that still exist up until the size of about 10 billion. As the bank does provide a range of services, it probably does benefit from economies of scope. d. This firm appears to be outside of the range where any economies of scale exist. However, the evidence for economies of scope is clear as the bank provides a wide range of services. e. This firm appears to be outside of the range where any economies of scale or scope exist.

Which federal law or laws apply to each of the situations described below? a. A loan officer asks an individual requesting a loan about her race b. A bill collector called Jim Jones three times yesterday at his work number without first asking permission c. Sixton National Bank has developed a special form to tell its customers the finance charges they must pay to secure a loan d. Consumer Savings Bank has just received an outstanding rating from federal examiners for its efforts to serve all segments of its community e. Presage State Bank must disclose once a year the areas in the local community where it has made home mortgage and home improvement loans f. Reliance Credit Card Company is contacted by one of its customers in a dispute over the amount of charges the customer made at a local department store g. Amy Imed, after requesting a copy of her credit report, discovers several errors and demands a correction

a. This is prohibited by the Equal Credit Opportunity Act. b. This is prohibited by the Fair Debt Collection Practices Act. c. Disclosure of all charges are required under Truth in Lending Act. d. Ratings are provided under the Community Reinvestment Act. e. Disclosure required under the Home Mortgage Disclosure Act. f. This is a consumer's right under Fair Credit Billing Act. g. This is a right under the Fair Credit Reporting Act.

What are the essential differences among working capital loans, open credit lines, asset-based loans, term loans, revolving credit lines, interim financing, project loans, and acquisition loans?

a. Working capital loans are short-run credits to fund the current assets of a business, such as accounts receivable, inventories, or to replenish cash. Usually a working capital loan is designed to cover seasonal peaks in a business customer's production levels. Normally, working capital loans are secured by accounts receivable or by pledges of inventory and carry a floating interest rate on the amounts actually borrowed against the approved credit line. b. Open credit lines include a credit agreement allowing a business to borrow up to a specified maximum amount of credit at any time until the point in time when the credit line expires. c. Asset-based loans are secured on the basis of the shorter-term assets of a firm that are expected to roll over into cash in the future. Generally, the amount and timing of the credit is based directly upon the value, condition, and maturity of certain assets held by a business firm (such as accounts receivable or inventory) and those assets are usually pledged as collateral behind the loan. d. Term loans are business credit that have an original maturity of more than one year and are normally used to fund the purchase of new plant and equipment or to provide for a permanent increase in working capital. Term loans usually look to the flow of future earnings of a business firm to amortize and retire the credit. Term loans normally are secured by fixed assets (e.g., plant or equipment) owned by the borrower and may carry either a fixed or a floating interest rate. e. Revolving credit lines are lines of credit that promise the business borrower access to any amount of borrowed funds up to a specified maximum amount; moreover, the customer may borrow, repay, and borrow again any number of times until the credit line reaches its maturity date. It is one of the most flexible of all business loans, and is often granted without specific collateral and may be short-term or cover a period as long as five years f. Interim construction financing involves bank funding to start construction or to complete construction of a business project in the form of a short-term loan; once the project is completed, long-term funding will normally pay off and replace the interim financing. g. Project loans are basically given to support the startup of a new business project, such as the construction of an offshore drilling platform or the installation of a new warehouse or assembly line; often such loans are secured by the property or equipment that are part of the new project. h. Acquisition loans are made to finance mergers and acquisitions of businesses. Among the most noteworthy of these acquisition credits are leveraged buyouts of firms by small groups of investors.

What steps that management can take appear to contribute to the success of a merger? Why do you think many mergers produce disappointing results?

· They can know themselves by thoroughly evaluating their own financial condition, track record of performance, strengths and weaknesses of the markets it already serves, and strategic objectives. · They can also create a management-shareholder team before any merger to do a detailed analysis of the potential mergers and new market areas. · Establish a realistic price for the target firm based on a careful assessment of its projected future earnings discounted by a capital cost rate that fully reflects the risks of the target market and target firm. · Once a merger is agreed upon, create a combined management team with capable managers from both acquiring and acquired firms that will direct, control, and continually assess the quality of progress toward the consolidation of the two organizations into a single effective unit that satisfies all federal and state rules. · They should also establish lines of communication between senior management, branch and line management, and staff that promotes rapid two-way communication of operating problems and ideas for improved technology and procedures. · Create communications channels for both employees and customers to promote (a) understanding of why the merger was pursued and (b) what the consequences are likely to be for both anxious customers and employees who may fear interruption of service, loss of jobs, higher service fees, the disappearance of familiar faces, and other changes. · Finally they should set up customer advisory panels to comment on the merged institution's community image, availability of services and helpfulness to customers. Mergers sometimes produce disappointing results because of ill-prepared management, a mismatch of corporate cultures, excess prices paid by the acquirer, inattention to customers' feelings and concerns and a general lack of fit between the two firms.