All Banks (or any type of lender) have a fundamental obligation to attempt to identify and avoid lending practices that could place vulnerable customers at a disadvantage. The following are examples of good responsible lending practices:
As I previously touched on here, liquidity risk is currently the greatest risk faced by Banks – the credit crisis highlighted the risks banks face when relying on access to short term funding provided by global money markets to fund their long term loan portfolios.
In New Zealand, the Reserve Bank has replaced it previous “passive” approach to banks liquidity management to a more “active” approach and have introduce minimum requirements for banks liquidity levels. The primary requirement is what has been termed as “core funding ratio” – caluated as follows:
Core Funding Ratio : One year core funding dollar amount / total loans and advances
The Reserve Banks policy can be viewed here, but requires Banks to have a 65% core funding ratio, increasing over time to 75%.
The key to the ratio is understanding what qualifies as “one year core funding”. The Reserve Bank prescribes it as :
1. All funding with residual maturity longer than one year, including subordinated debt and related party funding.
2. plus 50 per cent of any tradable debt securities issued by the bank with original maturity of two years or more and with residual maturity at the reporting date of more than six months and not more than one year
3. plus non-market funding that is withdrawable at sight or with residual maturity less than or equal to one year, applying the percentages within each size band
Up to $5m – 90%
$5m to $10m – 80%
$10m to $20m – 60%
$20m to $50m – 40%
Over $50m – 20%
4. plus Tier 1 capital
In short, the ratio will require banks to hold a greater portion of longer term funding and will encourage banks to hold more smaller tranches of on-call or short-term funding – such as retail deposits.
Where construction is by way of full turn key contract the following is required;
• Copy of a registered valuation addressed to The Bank from an approved valuer advising the value of the property upon completion, with property details based on the customer’s plans and specifications.
• Copy of full turn key contract confirming that all work is to be completed, including landscaping, driveways, fencing etc as detailed in the schedule of work, specifications and contracted payment schedule
• Under no circumstances are any amendments or variations to be made to the contract, either prior to or during the construction process without prior consultation with The Bank & subsequent approval for the changes from The Bank. This includes items within the contracted price being paid for from the clients own funds.
• Sale and purchase agreement for section (if applicable)
• Copy of local authority consents/permits and full builders risk insurance policy/details
• The loan is assessed in the first instance, for affordability purposes only based on the total loan facilities and is not formally approved for construction until such time as the Bank’s full construction policy is met.
Loan drawdown requirements where construction is by way of full turn key contract are;
• Customers own funds are to be utilised before any loan funds are drawn.
• Drawdowns will be against invoices as per scheduled payments contained in the contract for all transactions.
• For all loans where final LVR exceeds 90% drawdowns will be against invoices as per scheduled payments contained in the contract and supported by receipt of registered valuers certificate confirming cost expended to date, value of work completed and cost to complete.
• Value of remaining undrawn finance is not to exceed the cost to complete figures as shown in the full turn key contract.
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The 5 C’s of credit are a common approach to the principles related to credit decisioning; they are:
Character
Includes the potential borrower’s history, structure, quality and expertise of management, shareholders/stakeholders, product offering, and reputation.
Capacity
Refers to the borrowers ability to repay the loan on time
Capital
Capital refers to the firm’s financial reserves or the value of equity shareholders have in the business
Conditions
Conditions refers to the general economic and business sector conditions faced by the borrower.
Collateral
Whats is protecting the lender if borrower falls into trouble. Ideally, collateral should be marketable and readily saleable without being subject to wild price fluctuations.
Commercial loans can be complex and are generally high dollar value and carry relatively high credit risk. Proper analysis is paramount in loan selection and pricing. Ongoing reviews are required to alert lenders to issues that may require action to protect their interests.
Loans for working capital purposes require an understanding of the borrowers business cycle and corresponding cashflow forecasts – loan facilities might be structured to meet the funding requirements at various points in the business cycle. The lender must also ensure that the purpose of the loan is fully understood – whilst the funds might be provided to meet working capital requirements, the borrower may mislead the lender and utilise the funding for other purposes – such as capital expenditure – resulting in a cashflow shortfall at some later point. This might be controlled via loan covenants. Most importantly, the lender must ensure that the loan commitments can be met by the cashflow predictions of the business – this would include detailed understanding of business receivables and past performance.
Other commercial loans are generally longer term loans utilised by the company to purchase an asset. A detailed understanding of the asset being purchased is required – does the cashflow from the asset service the facility – and will it continue to service the facility over the full term of the loan.
In addition to cashflow analysis, the companies past financial statements will give a good indication of future performance – generally the banks risk management polices will stipulate minimum financial performance ratios, these ratios will be based on ratios of other companies that have a proven debt servicing history – these ratios will also help assign a risk grade of the borrower. A lender will need comfort that past profits would be sufficient enough to support the new facility, not withstanding the projected increased revenue from assets being purchased as part of the subject loan.
Non-performing Loans as % of Total Loans
The ratio of loans that are greater than 90 days past due + Impaired loans as a percentage of total loan book. This ratio is the best indicator of likely losses in the loan book.
Provision for Loan Losses over Average Assets
The provision for loan losses is a charge to current earnings to build an allowance for future losses. It is the risk manager responsibility to ensure provisions (aka reserves) is sufficient to absorb probable loan losses.
Loan loss provisions as a percentage of Non-performing loans
This ratio provides an indication of the adequacy of a bank’s loan loss reserve to cover or absorb possible future loan losses. It is sometimes called the “coverage ratio” because it gives an indication of how well the reserve covers potential loan losses.
Net Interest Income over Average Assets
Net interest income is the difference between interest income and interest expense. It is the gross margin on a bank’s lending and investment activities. Small changes in a bank’s lending margin can translate into large bottom line changes. High margins are generally represent a high risk and high yield loan and investment book.
Net Income over Average Assets (Return on Assets – ROA)
A ratio representing bottom line performance – can also use Return on Equity ratio (ROE) which demonstrates the return on the shareholders investments – for financial institutions, anything above 20% ROE is considered good.
I recently read a great blog by Ed Kim, you can read it here
Basically, Ed details his thoughts of what’s required to be an effective risk manager – I particularly agree with the following two principles :
Never compromise integrity. A risk manager’s responsibility is directed to ensuring that the organization is abiding by all requirements as set forth by law, regulations, and its own policies and procedures. Staying your course in not compromising one’s integrity does not win you any favors, However, the risk manager is charged with the sacrosanct responsibility of being the beacon of rationality in face of blind greed.
Don’t sugar coat the truth. In the corporate world, the managers are in their position for a reason. They should be mature enough to accept the facts and consequences of the facts without the need for circumlocution. However, good business practice is to recommend choice of action plans to the manager. This way, the risk factors are properly “actioned” and potential losses minimized or even mitigated.
I thought I’d provide some brief detail on some common forms of financial market instruments. Hopefully there are some experts out there that might like to contribute to this post and provide some more detail.
Firstly there are 2 types of markets – Money Markets and Capital Markets. Money Markets relate to short term borrowing or lending and Capital Markets relate to longer term instruments.
Equities
Equities or shares are forms of ownership in a company, share in public companies are traded in an open market – eg. NZX. Private equity is not as freely tradable. I’ve read that the global public equity market is greater than US$40 trillion. ($40,000,000,000,000)
Bonds
Bonds are debt securities, typically issued over a 5 – 10 year term. Purchasers of Bonds (bondholders) are creditors of the company and have priority over shareholders if the company went into liquidation. Bondholders do nor hold any ownership rights. Bond holders are paid periodic interest payments, referred to as coupons.
Treasury Bills (TBills)
These are government issued debt securities generally with very short maturities. Given that they are issued by the government, credit risks associated with TBills are low.
Since late December 2008, New Zealand treasury bill issuance has increased from around $200 million to $500 million per week in three and six-month maturities
Commercial Paper (CP)
These instruments are issued by Corporates or Banks (very common with NZ Banks) to fund their short term credit requirements. The instruments are unsecured and generally have a maturity of less than 12 months – pricing is determined mostly from an institutions credit rating.
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Liquidity management has in the past been the poor cousin of risk management principles – one for the theorists. However, since the credit crunch its now probably the most challenging hurdle faced amongst Bank directors.
Liquidity is the ability of a bank to fund increases in assets and meet obligations as they come due.
Banks are inherently vulnerable to liquidity risk as their business model involves “lending long and borrowing short”. eg. they provide home loan funding to a borrower over 25 years, however the money they use to fund this is typically borrowed by the bank over a much shorter period.
Banks funding models = illiquid assets funded by highly liquid liabilities
Banks typically manage this position by utilising an array of different funding options from retail to wholesale money markets with an array of Maturity concentration limits.
The Basel Committee recently outlined 17 principles-based recommendations on liquidity management, you can download it here
Lending covenants are an important tool for any lender to monitor and protect its position. Breaches of covenants are generally an early indicator that the borrowers financial position has deteriorated. Generally, when talking about covenants its in relation to corporate exposures – but almost all lending has covenants attached, including home loans eg. the requirement to hold current insurance over a mortgaged house.
Covenants take the form of affirmative covenants (e.g. maintaining certain financial ratios) and negative covenants (e.g. limiting the sale of assets).
Common covenants include:
- Minimum interest coverage – earnings over interest expense
- Leverage covenants – total debt over assets (or equity)
- Liquidity – current assets over current liabilities
- ROE – minimum return of equity requirements
- Restraint on dividend payments
- Provision of financial data
Normally covenants are taylored specifically for the risks associated with an individual borrower.
When a borrower breaches a covenant, the lender may charge a fee or increased interest rate, they may reduce the credit facility or “pull it” completely.
If more than one lender is involved, the process to establish covenants takes time and may require several proposals.
Recently, Banks have been paying more attention to covenants … A great article from the NZ listener on this topic can be found here
Here’s an extract:
Even for the banks, compliance with covenants was “just not something that seemed to be on the radar” during the boom. “The banks at each annual review would have had to tick that box, but now they are asking for more regular reporting, and because they are managing their risks, they are monitoring things more [closely]. It’s all about getting early warning signs …
