im09 - Chapter 15 Overview of Credit Policy and Loan...

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Chapter 15 Overview of Credit Policy and Loan Characteristics Chapter Objectives 1. Describe recent trends in bank loan growth and quality and data for different-size banks. 2. Provide an overview of the credit process at commercial banks. 3. Describe the characteristics of different types of loans. 4. Explain what negative and positive (affirmative) loan covenants are. 5. Introduce cash-to-cash cycle comparisons for working capital loans. Key Concepts 1. Loans are the dominant earning asset at most commercial banks comprising between 50% and 80% of total assets. Real estate loans are the dominant loans for most banks, but loan composition for individual banks reflects management’s strategies and target markets. 2. Since the early 1990s, loan quality has improved dramatically as loan charge-offs and noncurrent loans have decreased sharply. Only credit card loans experienced rising loss rates, which is particularly disturbing given the robust economic conditions in the U.S. during the 1990s. Starting in 2000, recent data show an increase in noncurrent and problem loans across many different types of credits. The increase appears to be particularly strong for commercial and industrial loans and loans to individuals. The number of bankruptcy filings and credit card charge-off rates continue to rise as well. 3. The credit process involves three functions: business development and credit analysis, credit execution and administration, and credit review. Credit analysis involves the examination of the risks inherent in making a loan and largely determines whether a bank wants to extend credit to the prospective borrower. 4. Two types of commercial loans are short-term working capital loans and term loans for the purchase of depreciable assets and/or facilitating mergers and acquisitions. Working capital loans typically require a complete payoff within one year as trading assets are liquidated. Term loans have maturities beyond one year and are repaid from operating cash flow. 5. The working capital cycle compares the timing difference between converting current assets to cash and making cash payments on current liabilities and operating expenses. The cash-to-cash cycle is a measure in days of the time it takes for the underlying firm to convert assets or liabilities to cash. The difference in the asset cash- to-cash cycle and liability cash-to-cash cycle provides information about a firm's potential working capital borrowing requirement. The greater is the asset cash-to-cash cycle, the greater is a firm’s potential borrowing needs. 6. Loans for real estate, agriculture, and other specific purposes generally exhibit features associated with the assets financed or cash flow sources of the borrower. Such loans are priced according to the specific terms of each loan. 7. Consumer loans differ from commercial loans because they are smaller in size, are often repaid in installments,
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im09 - Chapter 15 Overview of Credit Policy and Loan...

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