Bank Lending

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• Publisher: Wiley
• Year: 2012
• Print ISBN: 9780470827451
• eBook ISBN: 9780470827482
• Edition: 1
• Topic: Economics
• Subtopic: Banks & Banking
• Index: Economics

Sophisticated banking is vital for modern society to function and prosper. Banks lend to individuals and corporations but do so after carefully exploring the risks they undertake to each customer.

This book examines the important role of lending in banking operations and how banks can implement safe and effective loan initiatives. Banks rely on lending to generate profits, but it can be a risky venture. It is important for banking professionals to understand how to mitigate those risks.

Bank Lending from the Hong Kong Institute of Bankers discusses a variety of topics that impact a bank's loan strategy. This is an essential read for candidates studying for the HKIB Associateship Examination and those who want to acquire expert knowledge of Hong Kong's bank lending system.

Topics covered in this book include:

• Assessing and reducing lending risk
• Understanding the customer through financial statements
• Using ratios to determine risk
• Setting up an internal structure to reduce risk
• Pricing and managing loans

Dah Sing Bank is delighted to sponsor this resourceful book. The Dah Sing Group is a leading financial services group in Hong Kong, active in providing banking, insurance, financial, and other related services in Hong Kong, Macau, and the People's Republic of China. The Dah Sing Group has gained a reputation as one of the most progressive and innovative financial services groups. Keys to its success are the strength of the Dah Sing management team and the group's commitment to serving its customers.

PART 1

PERSONAL AND CORPORATE LENDING

CHAPTER 1

Lending to Personal Customers

Learning objectives

After studying this chapter, you should be able to:

1 Discuss general lending principles in advances to personal customers

2 Explain the types and purposes of lending to individuals

3 Describe the characteristics of residential mortgage loans and how interest rates and other fees are computed

4 Explain the various home ownership schemes in Hong Kong and the role of the HKMA and HKMC in Hong Kong’s mortgage loan market

5 Understand the process of evaluating personal credit applications

Introduction

Lending money is the business of banks. Banks lend to individuals and corporations on the condition that it will be returned after an agreed period, usually with interest and fees. But lending is inherently risky. Repayment of a loan and interest on it depends on the future cash flow of the borrowers, and that future cash flow can never be certain. To be successful, banks need to ensure that the risks they take are reasonable and controlled within defined limits.

In this chapter,1 we discuss the process of lending to personal customers, the types of loans that banks typically make available to them, and how banks can reduce the risk that these advances to individuals will not be repaid. Let us first learn about the general lending principles in making loans to personal customers. To make these principles more memorable to practitioners, they are usually arranged into easy to remember mnemonic devices such as CAMPARI, 5Cs, PARTLAMPS and PARSER.

General Lending Principles

You may know Campari as an alcoholic drink obtained from the infusion of bitter herbs, aromatic plants, and fruit made by Italy’s Campari Group. In banking, though, CAMPARI stands for the initial letters of the factors that banks consider when making a decision as to whether or not to extend a loan to a personal customer: Character, Ability, Margin, Purpose, Amount, Repayment, and Insurance.

• Character. Before extending credit, the bank must be certain of the borrower’s character. How reliable is the borrower’s word regarding the details of the application and the promises made to repay? Is the borrower making overly optimistic claims?
• Ability. An individual borrower’s ability to repay can partly be gleaned from the manner with which he or she handles financial affairs. Is there adequate cash flow in present earnings? The bank should examine the borrower’s proof of income against his or her bank account records (such as bank statements), credit card statements, and references from banks and credit agencies. It should watch out for red flags such as personal cheques being dishonoured for lack of funds, frequent requests of stop payment on issued cheques, excesses on agreed facilities, and loans not being repaid on schedule.
• Margin. The margin expected by the lender should never cause it to underestimate or set aside the risk. The interest rate and fees to be charged for each loan application need to be commensurate with the risk perceived. The bank should decline any loan application where repayment is in doubt.
• Purpose. The bank should know the customer and the reason for the application. It should lend only for good causes and not for illegal purposes such as smuggling.
• Amount. The bank should ascertain if the amount of the loan requested is reasonable, if it matches the purpose, and if it is in proportion to the resources of the customer. In lending to personal customers, banks rely on the borrower’s income. In general, the higher the income, the more prepared banks are to lend a greater proportion of the needed amount.
• Repayment. Does the borrower have sufficient capacity to pay whether through recurrent cash flows, disposition of a single asset, or anticipated income? If possible, the bank should arrange repayment through an automatic monthly debit from the borrower’s salary. It should match the repayment period with the nature and purpose of the borrowing (e.g., a car loan does not usually exceed three to four years while a home mortgage loan may be granted for 25 years or even longer). The bank should be cautious of borrowers who change banks, particularly those who badmouth their previous banks. The bank should always be prepared to say “no” to any borrower who rushes it into a lending decision.
• Insurance. The bank should consider if some form of security is necessary, but should remember that security is not a substitute for repayment. The security must be measurable and stable in value, simple to take, easy to sell and liquidate, and must be legally enforceable. If in the form of real property, the title must be clean and transferable. The bank should be conscious of the difference in the market value and forced sale value of a security. It should always include a realistic margin to allow for the costs of realisation and the discount to be expected on a forced sale or a fall in the market.
  Another form of acceptable security is through a personal guarantee from a third party. Under the Code of Banking Practice, which is issued jointly by the Hong Kong Association of Banks and the DTC Association and endorsed by the Hong Kong Monetary Authority, the lender must apprise the personal guarantor of the risk by requiring him or her to take independent legal advice before signing any guarantee.

Besides CAMPARI, there are other easy-to-remember lending acronyms in use, such as 5Cs (character, capital, capacity, collateral, and condition); PARTLAMPS (purpose, amount, repayment, time, laws, accounts, management, profitability, and security); and PARSER (person, amount, repayment, security, expediency, and remuneration). All these acronyms deal more or less with the same elements and principles, and it is up to the individual bank to decide which ones are most useful for its own circumstances or to devise a lending acronym of its own.

Types of Personal Customers

To flesh out and apply the general lending principles, it is helpful for the banker to learn the types of personal customers that exist. Loan applicants can roughly be broken down into four categories, depending on how they earn their livelihood:

• Salaried employees. These applicants are permanent employees who typically receive a monthly salary, 13th month pay, overtime, allowances, and performance bonuses. Among the key factors to examine when dealing with salaried employees are the total compensation package, length of employment, and the employer’s industry and reputation.
• Self-employed. These borrowers own and run their own business, such as restaurants, hair salons, laundry services, or market stalls, or rely on freelance project-based work, such as journalists and editors. Because their living typically comes from a small enterprise, the risk of lending to self-employed persons is higher than for salaried workers. Banks need to closely examine assessments for profit tax by the Inland Revenue Department, financial statements, bank records, and other documents in lending to self-employed borrowers.
• Professionals (e.g., accountants, architects, doctors, engineers, and solicitors) can be self-employed with their own practice or salaried employees of companies, or a combination of the two. The risk of lending to professionals can be lower than that of lending to the self-employed, since professionals have specialised skills and qualifications and can charge substantial fees. Nevertheless, their income can be volatile depending on their reputation and the need for their services. Banks should take into account the stability of the profession—accountancy and medicine are typically seen as more stable professions than architecture and entertainment, for example.
• Wage earners or blue-collar workers are generally regarded as the most risky borrowers because they usually do not have job security and are paid by actual work done. If they are factory workers, they may not be entitled to wages if the factory is idle. If they are truck drivers, they may not be paid if there are no deliveries to be made.
• Private investors are those who invest in property, the stock market and other assets to make a living or supplement their income. They are typically retirees, housewives, or career people who gave up their jobs to focus on investing their money for profit.

The borrower’s means of...

Table of contents

• Cover
• Contents
• Title
• Copyright
• Preface
• Part 1: Personal and Corporate Lending
• Part 2: Corporate Credit
• Index