Good Lending Principles and Techniques for Commercial Banks
Good Lending Principles and Techniques for Commercial Banks – Lending has become a vital function in banking operations because of its effects on the economic growth and development.Banks mobilizes funds from surplus economic units and channels it to the deficit economic units in forming loans and advances lending is banking. A bank does not go ahead to advance money because a project proposal sounds fantastic without through economic and financial analysis nor do they just advance funds solely on the strengths of the collaterals presented, but where this negligence abound, the out come is usually unpleasant.
PRINCIPLES OF GOOD LENDING:
The economic growth, business and commercial development of any nation is achieved through the enviable lending role performed by its banking financial and quasi-financial institutions.
In most developing countries of the world, the lending function has become so paramount that it has persistently been integrated into government policy formation in the National Economic development process.
The lending objective of the bank is to provide funds for growth and development, encourage savings and investment, and to maintain profitability and liquidity.
Lending requires development of clear-cut loan policies, loan review programmers etc. Lending could be informed of overdraft or term loans with varying degrees of disbursement, moratorium and interest aim principal repayment. Bankers should ensure maximum liquidity to depositors and profitability to shareholders.
Bankers in their dealings with customers are not charitable organization, thus they serve on profit by extending credit in line with some sort of economic criteria.
ADEKANYE (1984), in supporting this view contended that “it is a well known fact that banks are businesses established to make profits and not as charitable organizations. Therefore, any facility granted is expected to yield some profit to the bank”.
A bank does not just extend credit to customers because it is sought for, rather, it is based on certain yardsticks which “CLASHORE (1985)” suggests includes, the purpose for which the loan is required, the feasibility of the project, the capacity or experience of the proposal or customer to successfully prosecute the business or project, the integrity of the borrower and the security offered for the facility.
Invariably, what is being advocated for, is the exercise of care and prudence in banks’ lending officer is approached for a loan or overdraft facilities, he should obtain satisfactory answers to some basic questions which we have described as canons of lending. This he expressed as:
1. How much does the customer want to borrow?
2. Why does the customer want the loan / overdraft?
3. Is the customer’s business financially strong enough to keep going, if his plans suffer a set back?
4. How long does he want the facility?
5. How does he intend to repay?
6. Then consider your general assessment of the customer.
According to NWANKWO (1980), effective lending in a developing economy may be defined as “that quantum of lending which maximizes the bank’s objectives of liquidity and profitability and the economy’s objectives of development. It therefore, becomes necessary to know the desiring loan facilities since this could determine whether or not, the business has a bright future.
CLASIHORE (1985), compliments this view by saying that “when a lending officer lack the competence for analytical appraisal or allows himself to be misled or carried away by consideration outside the normal cannons of good lending, he is likely to make wrong judgment in selecting his risks.
He went further to assert that “a lending officer must be upright, fearless and dynamic and must not be allow his personal / social relationships to becloud his judgment.
According to UZOAGA (1981), assessment of risks is based on the applicant’s character, capacity, collateral and co-signors that the applicant provide.
CLASHORE (1985), supporting this view, went on to say that “looked at from this point of view, there are certain elements which lending officers considers in determining whether to extent credit, and if so, how much.
The basic factors are called the four (4) c’s of credit- CHARACTER, CAPACITY, CAPITAL AND COLLATERAL. He concluded his opinion adding that these factors “are infact, aimed at aiding the successful performance of the lending function.
ADIKWU (1983), in his credit evaluation simply referred character and integrity of the loan seeker is very important to the banker. This is because the bank has to provide loan to a person of transparent honesty who will be willing to repay the loan on maturity without being compelled to do so. A banker can know the character of his customer through banker / customer relationships, when there are doubts, he can make references and obtain status report through available sources.
According to HALE (1983), the character of the borrower “must be free of any doubt as to their integrity. He contends that if any questions as to the integrity or good intentions of the borrower arise, the creditor should not approve the loan, but rather check the moral standing and style of business before beginning negotiations. This he feels is necessary since “banks who associate with people of less than acceptable character damage their own reputation far beyond the profit obtained from the transaction.
PANDY (1981), indicated character as “the willingness of the customer to pay”. The need to pay attention to this factor was accepted by the ENCYCLOPEDIA BRITANNICA (1991), since it asserts that an earnest intention to repay even in adverse circumstances is essential.
PANDY (1981), summary described capacity as the ability of the customer to pay. Banks are interested not only in the borrowers ability to repay but also in his legal capacity to borrow. Usually loans are not extended to minors, since they can disaffirm at a later date unless the proceeds of the loan are used for essential purposes.
An examination of the previous track record of the loan seeker will reveal, if the applicant has the technical and managerial know-how to execute the project for which the loan is being sought.
Bankers understandably give priority to satisfying themselves that the management of the borrowing firm appears reasonably competent.
To ascertain the capacity to repay in the case of limited liability company- the memorandum and Articles of Association, certificate of incorporation and a resolution authorizing the directors to borrow a stated amount order is required so as to avoid bad debt. In the case of partnership, the partnership deed should be examined.
This measures the property risk. Capital serves to protect the creditor against undue losses especially during the period of liquidation.
The customer’s capital contribution to the project financing must be reasonable. Where s banker takes up the financing of almost all the stages of a project, the borrower may not get involved so deeply in the execution of the job because his stake in the project is relatively low.
The risk of failure is borne by the banker. As a result of this, bankers must insist that the fund seeker should contribute a reasonable proportion of the project finance.
Collateral security merely act as an insurance against unforeseen circumstances which may render the proposed loan repayment plan difficult or impracticable.
Collateral security consideration for bank lending has therefore become a necessity, to lower the risk of loss on a loan by requiring back-up support for a loan beyond normal cash flow. This can take the form of assets held by the borrower or an explicit guarantee by a related firm or key individual.
Collateral is the security a bank has in assets owned and mortgaged / pledged by the borrower against a debt in the event of default.
Banks look to collateral as a secondary source of repayment when primary cash flows are insufficient to meet the debt service requirement.
Banks selects collateral that retains its value over time and should be listed firms, life policy, plant, equipment, real-estate third party guarantee etc.
In general a loan should not be approved on the basis of collateral improves the bank’s position by lowering its net exposure, but it does not improve the borrowers ability to generate cash to repay the loan.
Although, some writers refuse to include
CONDITION: As necessary factor to be considered in the extension of credit, but then it is discernable that the extension of credit to a customer might be influence by the consideration of the environment within which the business units and individuals operate Economic conditions.
The purpose of the loan must be within the regulatory lending framework provided by the central bank of Nigeria (CBN). The purpose must not be an illegal one because the Nigerian law punishes severely parties to illegal contracts. The banker should also consider the effect of the borrowing on the financial structure of the borrowing firm. If a firm proposes to borrow on short-term solely for acquisition of fixed assets, the balance sheet would swing towards, borrowing short and investing long.
Since fixed assets are not usually swiftly saleable at a good price the effect would be to make the firm’s financial position riskier.
The amount sought by the customer should be adequate for his level of investment. Under-estimation of the firm’s needs may lead to difficult decision on “topping up” lending at a later stage, this nay lead to abandoning the project uncompleted and repayment may not be forth coming.
On the other hand, the amount requested might be excessive particularly in relation to the risk the bank is prepared to take. Judgment on whether the proposed level of borrowing is appropriate will depend on the bank’s assessment of the anticipated cash flows.
In appropriate cases, the requested amount may be scaled up or down accordingly by the lending banker.
Some firms are very vulnerable to economic fluctuations. Issues affecting firms stability deserve bank’s consideration when evaluating lending proposals. Financial statements for successive years covering the full business cycle should be studies, where the firm is found to be unstable for a reasonably long time, the bank should not be eager to lend.
After the approval of an advance, banks have to ensure that the performance of the firm is monitored.
This could be done through (a) regular demand for the firms records
(b) Monitoring of the project by physical inspection
© Monitoring of the conduct of the loan account to detect failure to meet loan account reduction as and when due.
The lending banker must ensure that the prospects of repayment are high.
Bankers do not like their loan to go bad. If a business enterprise is seeking financial accommodation, the analysis of financial statement should show that adequate cash flow could be generated to repay the loan.
Trend analysis of previous financial records of the firm will be of immense assistance to the banker in deciding whether the proposal is good or bad.
Banks usually insist on loan Amortization schedule for repayment.
LENDING CONCEPT: Undoubtedly, there has been in existence some concepts which had continued to influence the lending pattern in banking industry. Some bankers like ROY AND LEWIS (1971) affirmed that “like folk lores” they have passed from one generation of bankers to the other.
However, in a sequential historical order, the existing loan concepts can be outlined as:
(i) The real bill doctrine
(ii) The shiftability theory
(iii) The anticipated income theory
(iv) The liability management theory
As was emphasized by adequately enumerated by Adam Smith.
It is also known as the productive / commercial loan theory, it reiterate that if the bank can restrict its assets to real bills of exchange (ie bills supported by goods in transit). This will:
(a) Automatically limit in the most desirable manner, the quantity of bank liabilities
(b) Means that bank assets will be of such a nature that they can be turned into cash on short notice and this place the bank in a short notice and this place the bank in a position to meet calls for cash.
© Causes them to vary in accordance with the assets of business.
When the doctrine was in vogue in the banking industry, invariably the banks’ main source of liquidity apart from cash was them limited to their loan portfolio. There was no secondary reserve assets which could have served as a liquidity buffer for the banks.
The government securities then existing were not readily marketable
THE SHIFTABILITY THEORY
ADEWUMI,(1981) pointed out that a by the 1920s the commercial banks attitude to lending was beginning to deviate slightly from the prescriptions of the real bill doctrine. This was however attributed to the gradual but steady growth in governments borrowing from the public coupled with the increasing change in the structure of the bank’s total deposits base towards a greater proportion being accounted for, by the less volatile savings and time deposits With the emergence of the shiftable open market financial assets, the banks believed that the doctrine of commercial credit, need not continue to pay them to short-term loans, since they felt they could make good their liquidity shortages by shifting assets.
ANTICIPATED INCOME THEORY:
After a through study of banks term loans, PROCHNON (1949) came up with a new loan theory known as the “Anticipated income theory” as was expressed in WOOD WORTH (1971).
PROCHNON found in his study that “in every instances regardless of the nature and character of the borrower’s business, the banker planned liquidation of term loans for anticipated earnings of the borrower.
Liquidation is not by sales of assets of the borrower as in the commercial or traditional theory of liquidity nor by shifting the term loan to other lenders as in the shiftability theory of liquidity but by the anticipated income of the borrower.
THE LIABILITY MANAGEMENT THEORY
This theory emanated as a result of certificates of deposits (CDS) launched in 1961 by large new York money market banks. The emergence of this theory introduced another source of liquidity for the banks because of the issue of certificates of deposits.
Lending analysis is the process of inquiring prior to making the decision to lend. In this inquiry as “PROGER HALE” contends, the banker today does his best to replace emotional feelings, such as hopes and fears, with reasoned argument based upon a careful study of a borrower’s strength and weakness.
The fundamentals of modern analysis are two fold
(a) The examination of the nature of the borrower’s business in the context of its industry.
(b) The analysis of cash flows.
However, according to PANDEY, he contends that the applicant should be asked to provide the financial statements, which will form a basis to analyze the performance and trend of the applicant’s business activities.
Lending analysis therefore intended to keep the number of bad loans to minimum and to highlight a potential problem early enough to enable the lender to seek early withdrawal or repayment from the credit.
OUTLINE FOR LENDING ANALYSIS SECTION 1
DESCRIPTION, PURPOSE AND SOURCE OF REPAYMENT OF PROPOSED FACILITY
Each analysis is usually required to begin with a clear description of the proposed facility under consideration, with sufficient detail to identify.
(a) The borrower
(b) The type of credit facility
© The contemplated usage of the credit facility.
(d) The anticipated source of repayment should be stated
RISK ANALYST SUMMARY AND RECOMMENDATIONS
The analyst should state the pros and cons of extending credit and evaluate the credit risks sufficient to justify or impede the lending decision.
SOURCE OF INFORMATION
A detailed Background knowledge on the sources of information is required.
It should also indicate the financial statements which are being analyzed and whether the financial statements are audited or unaudites, if the analysis relies on the firm’s equity.
INTERPRETATION AND ANALYSIS OF FINANCIAL INFORMATION
The interpretation of information is geared towards the lending risks involved in the extension of the facility. The written interpretation and analysis of financial information should reflect the understanding and resourcefulness of the writer. To reinforce this statement (HALE 1983) asserts that “it is your decision and you must feel comfortable with it according to your own judgment.
TERMS OF LOAN AGREEMENT
Certain conditions are attached to offer of bank loans, such conditions and restrictions may include:
(1) PROHIBITION OF FURTHER CHARGES: The bank may prohibit creation of further charges on the fixed to protect the lending banker’s position.
(2) CHANGES IN MANAGEMENT: The loan agreement may demand that the lending banker approves major changes in management personnel or its composition.
(3) RENDERING OF FINANCIAL RETURNS: The banker may comps the borrowing customer to accede to regular monitoring of the business performance and submission of financial statements of the business to the banker on regular basis.
(4) RESTRICTION OF BENEFITS TO SHAREHOLDERS: The loan agreement may restrict the benefits accruing to the directors by way of drawings and dividends payable. The borrowing company may be compelled to satisfy the loan repayment before dividends are paid to shareholders.
(5) PROVISION OF INSURANCE COVER: The loan agreement usually provides that the borrowing customer should insure the property mortgaged for the loan and also keep it in good state of repair.
(6) REGULAR MONITORING: The bank may compel the borrowing customer to accede to regular monitoring of the business performance and submit regular financial information about the business.
Project monitoring is a control measure to ensure judicious application of funds by the borrowers.
ERRORS IN JUDGMENT
When evaluating loan requests, bankers make two types of errors in judgment. The first is extending credit to a customer who ultimately defaults.
The second is denying a loan request to a customer who ultimately would repay the debt.
In both cases, the banks focus on eliminating the first type of error, by applying rigid credit evaluation criteria and rejecting applicants who do not fit into the mold of the ideal borrower.
Good Lending Principles and Techniques for Commercial Banks