lending unit 4

THE UGANDA INSTITUTE

OF BANKING &

FINANCIAL SERVICES

UIBFS

ISO 9001:2008 CERTIFIED

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Module 3: Lending


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LEARNING OUTCOMES

After completion of this study you should be able to:

• Articulate the role of lending in the banking business

• Discuss the various aspects of a typical bank lendingcycle and highlight the key issues at each stage

• Explain the meaning of insolvency, bankruptcy andreceivership from the viewpoint of the lender.

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Lending in the Banking Business

General Principles of Good Lending

Types of Advances to Customers

The Practice of Lending

Securities for Advances

Corporate, Retail and Mortgage Lending

MODULE COVERAGE

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Typical remedies for Defaulting Borrowers

Insolvency, Receivership and its Effects


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Promotion

Application

Screening

Approval

Contracting

Disbursement

Administration

Repayment

Rejection

Receivership

Forceful recovery

The credit cycle


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Promotion • Banks promote themselves and their products in order to reach their

potential customers and also interest the current ones to take on newproducts. Promotion involves advertizing, public sensitization and otherways of disseminating product information to the public.

• Banks also use targeting in promotion, whereby the people that the bankwould like to serve with loans and other products are identified andpromotional activities specifically targeted at them.

Among such aspects that enhance the impact of promotion are;

1. Appropriate ProductsThe bank needs to have products that meet the needs of its current and

potential customers. It is important for branch staff to talk to clients andnon-clients regularly to identify ways to strengthen service and identifynew products or refinements to existing products that meet client needs.

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2. Appropriate information packaging and disseminationCredit and marketing officers could, alongside their usual work, gather

views on the need for the loan terms and features that customers like and then package their product information to appeal to them through:– Brochures– Radio and TV advertising– Cooperation with business clubs or groups– Presentations by branch staff to target customers or groups of them

3. Well trained StaffIn addition to acting professionally and in a friendly way, bank

employees need to communicate with clients effectively. Typically, bank customers now have many options and alternatives. The customer relationship staff need above average interpersonal skills.

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3. Simple proceduresAll people want simple procedures. Bank customers do not want to be

subjected to lengthy or complicated procedures because most of them are busy.

Some of risks associated with loan/credit promotion are;1. Ill-trained staff, failure to create impact2. Over-estimation of internal capability, causing client disillusionment later3. Failure to handle a large influx of prospects after a successful promotion4. Inadequately trained or unskilled staff disseminating wrong or unclear

information to the public5. Insufficient market research before big promotional campaigns6. Attracting wrong characters to apply for loans

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Loan application The loan application process differs among banks and products. In

some banks, the customer fills a simple or detailed application formwhile in others customers just write a letter accompanied bybankable feasibility study reports or business plans to be financed.In any case, the application must present adequate information forthe bank to screen and appraise the loan application/proposal.

Common risks with loan applications are:• Long process time, which if revealed to the customer could turn them

away.• Failure to respond to an application in a timely way can at times turn

away potentially good customers• Misplacement or loss of loan applications. With no effective loan

applications tracker within a bank’s MIS, it may not be easy to trace.• Falsification of information by the customer

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Screening and appraisal• Screening refers to the process of preliminarily selecting

from among several applications, only those eligible.Screening should be quick, fast and easy. If a loanapplication seems to meet the broad guidelines, it shouldbe taken to the next step in the appraisal stage.

• Once it is clear that an applicant is eligible and the loanofficer is satisfied with the application letter/form and anyother paperwork, then the appraisal process begins.

• However, there are some basic principles underlying theloan appraisal process regardless of the level of detail.These are known as the 5C’s of credit.

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• Character- The Character, credibility and reputation of theborrower is very important. Due diligence on a potentialborrower should be detailed, honest and objective. Sourcesof information for this could be the applicant’s otherbankers, suppliers, customers and friends.

• Cash flow – Whoever the bank lends to should haveadequate cash flows to service the loan without impairingthe continuity of their businesses. Both historical andprojected cash flows are useful in assessing this. A casualconsideration of the borrower’s past and projected futurecash flows could result in approvals of loans for borrowerswho may later fail to pay.

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• Credit worthiness – What is the state of affairs of the applicant? If they have borrowed so much that they are becoming insolvent, don’t lend.

• Cost – The cost of the loan in terms of interest paid should be more than covered by interest received. On the other hand, the loan should not be overly costly to the customer.

• Convenience – The location, procedures, delivery mechanisms and other requirements should be friendly and convenient to customers. If a bank’s methodology requires the customer to travel a long distance and then spend a whole day to submit the application, for instance, the client may lose interest.

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Capacity -The applicant needs to be screenedfor the adequacy of owners’ capital orcapacity, as already explained.

• There is also the issue of the absorptivecapacity of the client or his/ her business.The amount of loan disbursed to a clientshould be commensurate with the client’scapacity to utilize the whole of itproductively.

• Giving a big loan to a customer who onlyneeds little money may be a way ofencouraging delinquency right from thestart.

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• Staff inability to adequately appraise an individual loan application• Falsification of information by staff, just to get the application

through• Negative influence of wrong perception of the client by the CO• Conflicts of interest, depriving the credit officer of objectivity and

independence during appraisal. This may or may not involve compromise through bribe and dishonesty

• Difficulty and errors in evaluating the guarantors’ net worth – or not even attempting to evaluate it at all

• Over-valuation of security compared to realizable value.• Inadequate security ownership and particulars verification.• Client dishonesty; CO relies on inaccurate information

Potential risks pertinent to screening and appraisal:

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Approval Once appraisal is completed, it should be presented for approval. The

loan approval process needs to be clearly articulated. Personsand/or committees with the due authority should be the only onesto approve loans. The following aspects of the approval are worthnoting.

• Better in committee: To ensure that the applications are consideredobjectively and given all the necessary thought, approval is usuallybetter if done by a committee of three or four people. Thiseliminates biases, and can help in more effectively identifyingpossible risks and drawbacks.

• Well documented and formal: Loan approvals should bedocumented and signed by all committee members or by theperson with such authority. This helps in the pre-disbursementverification, when the officers are checking whether allrequirements have been complied with. If approval is by acommittee, there should be signed minutes verifying the approval.

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• Must precede every disbursement: As a matter of policy, it is good practiceto ensure that due approval is in place before every disbursement. Noloan funds should be released under any circumstances, unless signedapproval is in place.

• All aspects should be well considered: In considering the loan appraisalreport, the approving authority(ies) should consider all the relevantaspects plus any other aspects that might impact on the repayment abilityof the borrower. The “C” s of Credit should guide in such consideration.

• Documentation: Proper and clear documentation should accompany everyloan. These should be precise but adequate, and duly executed. At thevery minimum, the following should be in place.– Customer application– Approved appraisal report– Loan Agreement– Security Agreement(s)

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Security: Most loans should be secured in some way. The security could include one or a combination of the following:

1. Mortgage on real property (land and/or building)2. Fixed charge on any or combination of other fixed assets (chattel mortgages

included)3. Floating charges on all the borrowers’ present and future assets.4. Personal guarantee from a noteworthy third party, with the means to redeem5. Corporate guarantee from an institution6. Loan default insuranceApplicants with approved loans need to be given the following information;i. The amount that has been approvedii. The period/term approved (how long the loan will run)iii. Any administrative fee that will automatically be deducted or required upfrontiv. How the applicant will receive the loan When and where the loan contract will

be signedv. The interest rate vi. Any the other loan related terms and conditions

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Pending applications that require additional information should beconsidered in the loan committee as soon as possible. In cases of apending application, the branch manager should make a note onthe original application describing the condition(s) that must bemet before the loan officer can re-submit the application.

Applicants whose application is pending need to be contacted andtold:

1. Why the application is pending2. What is necessary to reconsider the application3. When to expect their application to be re-considered after

providing all the missing information.4. Rejected applications should generally not be reconsidered unless

there is new information to validate the applicant’s viability.

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Potential risks pertinent to approval:

• No clear guidelines for those sanctioning/ approvingloans and thus no uniformity of approval procedureand process – potentially aiding approval of some badloans

• Inadequately trained approval officers can do poorquality control, with the attendant deterioration in thequality of the portfolio

• Concentration of power in the loans committee mightinvalidate the usefulness of the committee.

• Rejecting good and high-prospect clients because of poor appraisal

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Contracting and documentation (Loan agreements)The next stage after loan approval is drawing up and executing the

loan contract(s). These should be legally binding and enforceable inall cases. The loan agreement and accompanying papers likedebentures, mortgage agreements etc should be registered.

• Failure to properly execute a loan contract in most cases manifest inthe crisis that follows default. When a defaulting customer resortsto legal challenge against the bank, a well prepared and executedcontract is often the bank’s only tool.

• Loan agreements are usually characterized either of two differentways: by the type of lender, or by the type of facility. Categorizingloan agreements by lender usually simply sub-divides loans into:

a) bilateral loansb) syndicated loans

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http://en.wikipedia.org/wiki/Syndicated_loan


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Categorizing loan agreements by type of facility, usually results in two primary categories:

a) term loans, which are repaid in set installments over the term, orb) Revolving loans (or overdrafts) where up to a maximum amount

can be withdrawn at any time, and interest is paid from month to month on the drawn amount.

Potential risks pertinent to contracting and documentation: 1. Wrong amounts, words or phrases erroneously inserted into the

contract, which makes enforcement difficult.2. Wrong or incomplete identification of the securities pledged.3. Difficulty in verifying ownership of assets pledged by the borrower.4. Too much confusing paperwork that the customer may fail to

understand5. Poor filing/ lost documents6. Inadequate understanding of loan contracting and security issues by

bank staff

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http://en.wikipedia.org/wiki/Overdraft


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Disbursement Disbursement is the transfer of money/value from the

bank to the customer or to the customer’s statedrecipient in respect of the loan. It is done in a numberof ways, including;• Crediting the customer’s current account• Transferring the money to the customer’s supplier(s)• Cheque or bank draft to the customer.

Disbursement requires good coordination among thebank’s staff and departments to ensure that loanprocesses are fully followed and that the customer isserved as quickly and effectively as possible.

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In particular, the loans officer needs to check that the following are in place;i. A fully completed loan application form and/or customer application letterii. An appraisal report by the credit officeriii. Signed approval of the loaniv. Proper authorization to disbursev. Loan amount and executed contract (i.e. signed, stamped etc.)vi. That all fees and other relevant charges have been received from the

borrower.vii. All security documents are in place.The point at which an applicant signs a loan contract is the point at which they

become (or reaffirm their status as) a borrower.

Some of the potential risks during disbursement: 1. Error in the amounts disbursed2. Failure to double-check that all the earlier processes and procedures were

duly followed

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MonitoringThe monitoring function is vital in bank lending. It is the stage of the

loan cycle that control of advances becomes critical to ensure thatgood advances do not become bad. It helps the bank’s creditdepartment to keep informed of the client’s business and to detectany potential threats to their continued ability to service the loan.Monitoring is also an effective way of continually appraising existingclients for repeat loans in the future.

Banks need to develop a set of risk detection criteria and early warningsystems. During monitoring the credit officers will watch out for anysuch signals. Monitoring activities should include the following;

• Regular or occasional visits to check on clients and their businesses• Demand reports from the borrowers• Regular (daily) checking of the borrower’s account

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Credit AdministrationCredit Administration is the back office function that ensures that the

client’s accounts are kept up to date, information is produced on atimely basis and is in useful formats, delinquency is tracked, anyaspects worthy noting about the customer are communicated andstandard portfolio as well as customer-specific reports are preparedon a regular basis.

Credit administration aids monitoring and the whole loan cyclemanagement by providing the required information.

What are the potential risks in monitoring & credit administration?1. The borrower might vanish and not be traced, making recovery

difficult or impossible.2. Credit officer could get compromised by the defaulting customer

and help him/ her cover the default3. Something unexpected happens to the client rendering otherwise

good clients unable to service the loans. For example loss ofbusiness, fire, disability or death.

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Repayment Repayment of loans, both principal and

interest, are usually made accordingto a pre-agreed schedule commonlyreferred to as a ‘loan repaymentschedule’. Normally, installmentsshould be paid on the due datesindicated in the repayment scheduleuntil the loan is fully paid.

Prompt repayment of loan interest andprincipal is an acid test ofcustomer/client loyalty and potentialof future repeat business

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