Loan Portfolio Management Note

Lecture note- loan portfolio management
Chapter One:
Introduction to Loan Portfolio Management and Loan Policy
The lending activity is the nucleus/heart of banking. Making loans' is the principal
economic (profitable) function of banks and their closed competitors. Bank loans
support communities and nations by providing credit to finance the development of new
businesses, sustain existing activities and create jobs so that the living standards can be
improved over time. The highest thinking in financial institutions is done in the lending
department.
Looking at the income statements of financial institutions, one will see that the most
profitable activity of these financial institutions is loan allotment or credit allotment.
The activity generates the highest income from interest received from loans given to
customers. The sales of financial institutions are the loans given to customers.
Loan portfolio management is the process by which risks that are inherent in the credit process
are managed and controlled. Because review of the LPM process is so important,
it is a primary supervisory activity. Assessing LPM involves evaluating the steps bank
management takes to identify and control risk throughout the credit process. The assessment
focuses on what management does to identify issues before they become problems. Effective
loan portfolio management begins with oversight of the risk in
individual loans. Prudent risk selection is vital to maintaining favorable loan
quality. Therefore, the historical emphasis on controlling the quality of
individual loan approvals and managing the performance of loans continues
to be essential. But better technology and information systems have opened
the door to better management methods. A portfolio manager can now
obtain early indications of increasing risk by taking a more comprehensive
view of the loan portfolio.
To manage their portfolios, bankers must understand not only the risk posed
by each credit but also how the risks of individual loans and portfolios are
interrelated. These interrelationships can multiply risk many times beyond
what it would be if the risks were not related.
The principles of good lending, called the canons of lending,

guide a bank's decision about whether or not to lend money.
When customers default these loans, this interest will not be paid, hence, a reduction in profit
and lack of liquidity to meet customers' demands.
The amounts advanced are not recoverable and are written off as bad debts and hence,
loan delinquency.
The costs of administering the amounts are much increased. Many expenses have to be
incurred, when customers default loans e.g. telephone bills, administrative costs, legal
charges and these expenses will affect profit in the income statement.
There are legal costs of chasing debts. Prudent bankers must be able to evaluate the
costs and benefits of taking a customer to court. This is usually the last option to take
because it is more expensive.
Loan Portfolios
The various types of loans given out by the banks are grouped into a single unit called a
loan portfolio. Therefore, a loan portfolio is a collection of all the bank loans with
different characteristics. Loan portfolio mix differs from one bank to another. There are
many factors that affect the growth and mix of loans:
Characteristics of the market area it serves: Each bank must respond to the demands
for loans arising in its own market. Banks that are located in big cities will have a large
portfolio of loans, because they are surrounded by office buildings, department stores,
and large manufacturing companies: Banks in such systems must devote the bulk of
their loan portfolio to business loans to purchase stock, equipment and run the day-to
day activities of the businesses. On the other hand, banks that are located in the small
towns with a large number of single-family homes and small retail stores will normally
Lender size: The amount of capital held by the banks determines their legal lending
limit to a single borrower. Larger banks are often wholesale lenders, which devote the
bulk of their loan portfolios to business firms, while smaller bank tend to emphasis on
retail loans, such as cash loans and home mortgage loans, as well as small business
loans.
The experience and the expertise of management: The management experience and
expertise in making different types of loans also determines the composition of the loan
portfolio, as some loan policies may prohibit the loan officers from making certain kind
of loans.
Expected yields: Banker must prefer to make loans that will generate the highest
returns after all expenses and taking loan loses into account.
Loan Segmentation
In the past, there were a few types of loans, simply due to the fact that there was no
competition in the banking system, but today, there is rigorous competition in the
banking system. Non- banking institutions are also in the economic system. They
compete even with banks in carrying out some banking transactions. It was reputable
for any customer in the past to say that he has a bank account, but today, banking is a
common noun in the quarters and villages. Micro financial institutions are located
nearly everywhere in the villages and as such, banking is very common. To cope with
the stringent competition, banks have built their loan portfolios to be very large, to
accommodate all the categories of customers in the economic system. This
segmentation is to reduce loan defaults and satisfy the different segments in the market
place. There is portfolio diversification, in the sense that there is spreading out of credit
accounts and deposits amount to a wide variety of customers, including many large and
small businesses, different industries and households in order to reduce the lender's risk
of loss. Loans portfolios consist of loans such as; school fees loans, mortgage loans,
project loans, real estate loans, household loans, working capital loans, business loans,
small scale retailer loans('buy and sell'), etc. The highest segmented bank in terms of
loans is APB.
What is a Loan?
A loan is a contractual obligation between the lender and the borrower on an amount
loaned, at specific interest rate, specific method of repayment and at a specified duration.
Loan Policy
Financial institutions need to make sure that their loans meet the standards needed by
the regulators. The most convenient way is to establish a written loan policy. A loan
policy is a document that gives loan officers and management specific guidelines used
in making individual loan decisions and in shaping the overall loan portfolio. It is a
document showing the various laws governing lending. The actual makeup of a
lender's loan portfolio should reflect what its loan policy says. Many financial
institutions, especially credit unions have their plans of what to do during lending, written in the
loan policy. These are produced in small handbooks and given to
customers, borrowers, etc, may be for a small token or for free. Many borrowers are
usually ignorant of many things about the loans types and the advantages and
disadvantages of each type. The ignorance usually gives birth to loan defaults. This is
coupled to lack of advice to these customers by the banks' officials. In this case, the loan policy
should be used to shape the mentality of customers who cannot properly carry out an appraisal
on the type of loan that he or she wants to take at any one time.
To the lending institution, the loan policy communicates to employees the procedures
that they must follow and their various responsibilities. It helps the lender moves
towards a loan portfolio that can successfully blend multiple objectives, such as
promoting profitability, controlling risk exposure, and satisfying regulatory
requirements. Loan policies should be flexible to changes in the economic environment
and regulations and violation of loan policy should be infrequent events.
A well written loan policy should contain the following elements:
- It should contain a goal statement for the whole loan portfolio. This means that it
should contain a statement showing the characteristics of a good loan portfolio, that
is, the types of loans, loan maturity dates (durations), loan sizes, and the quality of
loans.
- A loan policy should contain a specification of the lending authority given to each of
the loan officer, loan committee, BODs, etc. There should be a measure of the
maximum amount and the type of loan that can be approved by the loan officer, loan
committee and what signature of approval is required.
- It should show the lines of responsibilities in making assignments and reporting

information.
- It should also contain the operating procedures for soliciting, evaluating, and making
decisions on customer loan applications.
- A loan policy should indicate the required documents that will accompany each loan
application and what must be kept in the lender's files (e.g. financial statements,
security agreements, a copy of payslip, deed of conveyance, etc.).
- It should show the lines of authority detailing who is responsible for maintaining and
reviewing the credit files.
- It should contain the guidelines for taking, evaluating and perfecting collaterals.
- A loan policy should contain procedures for setting loan rates and fees, and the terms of
repayment of loans.
- It should contain a statement of quality standards applicable to all loans.
- It should show the preferred upper limit for the total loans outstanding (that is the maximum
ratio of total loans to total assets allowed).
- It should contain a description of the institution's principal trade area, for which most
loans should come.
- It should have the procedures for detecting and working out problem loans situations.
- It should specify what loans the lender is likely not to make, e.g. loans to finance birth
celebrations, marriages, feasting, dead celebrations, war, etc. These are not productive loans.
Credit Culture and Risk Profile
Understanding the credit culture and the risk profile of the bank is central to successful loan
portfolio management. Because of the significance of bank’s lending activities, the influence of
the credit culture frequently extends to other bank activities. Staff members throughout the bank
should understand the bank’s credit culture and risk profile. The knowledge should pass from the
chief credit policy officer to account officers to administrative support. Directors and senior
management should not only publicly endorse the credit standards that are a credit culture’s
backbone but should also employ them when formulating strategic plans and overseeing portfolio
management.
A bank’s credit culture is the sum of its credit values, beliefs, and behaviors. It is what is done
and how it is accomplished. The credit culture exerts a strong influence on a bank’s lending and
credit risk management. Values and behaviors that are rewarded become the standards and will
take precedence over written policies and procedures. A bank’s risk profile is more measurable
than its credit culture. A risk profile describes the various levels and types of risk in the portfolio.
The profile evolves from the credit culture, strategic planning, and the day-to-day activities of
making and collecting loans. Developing a risk profile is no simple matter. For example, two
banks with identical levels of classified
loans can have quite different profiles. Bank A’s classified loans might be
fully secured and made to borrowers within its local market, while bank B’s
loans are out-of-market, unsecured loan participations. Consider, as well,
how much more the failure of a $3 million loan would hurt a $500 million
bank than a $5 billion bank. The risk profile will change over time as
portfolio composition and internal and external conditions change.
Credit culture varies from bank to bank. Some banks approach credit very
conservatively, lending only to financially strong, well-established borrowers.
Growth-oriented banks may approach lending more aggressively, lending to
borrowers who pose a higher repayment risk. These cultural differences are
grounded in a bank’s objectives for asset quality, growth, and earnings.
Emphasizing one of these objectives over another does not, in and of itself,
preclude achieving satisfactory performance in all three. However, the
emphasis will influence how lending activities are conducted and may
prompt changes in credit policies and risk control systems. For example, a
bank driven to achieve aggressive growth targets may require more detailed
credit policies and more controlling administrative and monitoring systems to
manage credit risk properly. Consistently successful banks achieve a balance
between asset quality, growth, and earnings. They have cultural values,
credit policies, and processes that reinforce each other and that are clearly
communicated, well understood, and carefully followed.
The culture, risk profile, and credit practices of a bank should be linked. If
the credit practices and risk-taking activities of a bank are inconsistent with
the desired culture and policies, management should find out why and
initiate change to bring them back in balance. When practices do not
correspond to policies, lenders may not clearly understand the culture, credit
controls may not be effective, policies and systems may be inappropriate for
the credit environment, or employees may be rewarded for behaviors that are
different from those advanced by policy. If the risk profile deviates from
cultural norms, management should reassess the limits, policies, and
practices.
Steps Involved in the Lending Process
Finding prospective loan customers: The relationship between the bank and the
customer is a contract. This arises from a direct request from a customer who
approaches the bank's staff and is asked to fill a loan application form. (LAF)
Evaluation of the customer's character and sincerity of loan purpose: Once a

customer has decided to request for a loan, an interview with a loan officer usually
follows, giving the customer the opportunity. To explain his or her credit needs and for
the loan officer to assess the customer's character and the sincerity of the loan purpose.
Indigent character and lack of sincerity can be inferred from the interview with the
customer.
Making site visits and evaluating the customer's credit records and financial condition:
Sometimes, the
customer may apply for a mortgage or business loan, and in this case, the loan officer
will make a site visit to assess the customer's location, the condition of the property and
to ask clarifying questions. In the less developed world, there is a lot of untruthfulness
and therefore, some customers may present some property that may not belong to them,
to secure their loans. It is very important for the loan officer to contact some neighbours to verify
the true ownership of such property. The financial strength of the
customer can be verified from crucial documents submitted by the borrower, to fully
evaluate the loan request, including financial statements, and in the case of a company,
BODs' resolutions authorising the negotiation for the loan. After this evaluation, the
credit analyst division will present a brief summary and recommendation, which goes to
the manager and appropriate loan committee for approval. On larger loans, members of
the credit analysis division may give an oral presentation and discussion will ensue
between staff analysts and the loan committee over the strong and weak points of the
loan request.
Assessing possible loan collateral and signing the loan Agreement: When the
customer's request is approved, the loan officer or the credit committee will usually
check on the property or other assets to be pledged as collateral or can acquire title to
the property involved if the loan agreement is defaulted. This is often referred to as
perfecting the lender's claim to collateral. Once the loan officer and the loan committee
are satisfied that both the loan and the proposed collaterals are sourced, the note and the
other documents that make up a loan agreement are prepared and signed by all parties to
the agreement.
Monitoring in compliance with the loan Agreement and other customer service needs:
The endpoint of lending is not when the loan is handed to the customer. The
credit officer cannot put the loan files on his shelf and fold his hands. When the loan is
already handed to the customer, this is starting point of the credit officer's worry. The monitored
to ensure that the terms of the loan are being followed and all required
payments of principal and interest are being made as promised. For large commercial
loans, the credit officer will visit the customer's business periodically to check on the
firm's progress and see what other services the customer may need. Usually the loan
officer enters information about a customer in a computer file known as a customer
profile. This file shows what service the customer is currently using and contains other
information required by management to monitor a customer's condition and financial
service needs.
Chapter two
Credit evaluation /Principles of lending
Credit Rating and Credit Scoring

Credit rating is a process whereby banks assess the creditworthiness of their customers
before allotting loans to them. The credit officer is in position and his department has a
task to carry out these evaluations. The above criteria are used for credit rating. Credit
scoring refers to the process of calculating a numerical rating for a customer based on
information collected; credit is then granted or refused based on the results. A bank's
decision on whether or not to lend will be based on the following factors. The acronym
used is CAMP ARI or PRACTICE or 7Cs.
7Cs = Capital, Condition, Collateral, Character, Capacity, Cash and Control
CAMPARI = Capital, Amount, Margin, Purpose, Ability, Repayment and Interest.
The following canons or principles (factors) can be used to assess the creditworthiness of
customers.
1, Character of the Borrower
It refers mainly to the borrower's reputation for meeting obligations in good faith. To
many managers and credit officers, the customer's honesty and desire to pay are the
fundamental requirements for credit.
The character of the borrower can be established
and judged; even though difficult:
- The borrower's past records with the banks are examined.
- Personal interviews are mainly used business lending.
- Personal lending is more often credit scored (by the computer).
- In developed nations, the evaluations of the 5C's gives a total of 50marks and a customer is only
eligible for a loan if he or she is able to score at least 30marks.
- In the course of the country, the bank may look at key ratios which indicate the
country's performance. A ratio such as ROCE is vital. The limitation is that there
may be creative accounting or window dressing accounting.
Generally, human character changes every day. When a customer comes for a loan, he
is very respectful and submissive, but when he has received the loan, the other side of
the character will be seen and hence, managers are advised to be prudent when giving
out loans based on character.
2, Ability to Borrow and Repay
This is the financial ability of a customer to pay back a loan. The earning power can often be
evaluated by considering the general business practices of a customer. A
customer may have a good earnings power but the character may be a charm and will
impair his ability to pay the loan. The bank will look at a business customer's financial
position as an indication of future trends. The bank will also look at the customer's
financial performance in order to ascertain their likely future position. If the owner re-
invests profits in the business rather than drawings them all out, it shows that he has
some confidence in the success of the business. This makes the bank more likely to
lend to the business. When dealing with a company that is applying for finance, the
bank may check whether the company has the authority to borrow the funds it is
requesting. The company's articles of Association provide this information. Hopefully,
the loan will be invested in such a way as to generate profit. Bankers are advised to give
more productive loans. Loans given to customers for marriage celebrations must be
under special considerations. Bankers must also know the type of business to finance.
New business ventures are more risky and as such the prudent concept should be
applied. Re-investment of retained profits is a sign of the owner's faith in the business.
This means that the owner doesn't take all profits as dividends or drawings. Bankers
scour financial statements for signs of low or declining profitability, increased
dependency on borrowing, overtrading, inadequate control over working capital, and
sudden provisions delays.
Although the bank will use published accounts or management accounts, it will not lend
solely on that basis; in other words, the viability of the loan itself will be assessed.
Generally, the banker should check whether the company has the legal capacity to
borrow. A company might be prohibited by its article of association from certain types
of borrowings. Also note that the ability to borrow and repay lies in the character of the
borrower.
3, Margin of Profit
The bank lends money to make money and therefore, the decisions of interest are
important. It needs to ensure that it makes enough profit to warrant the risk that it takes
by lending. Most banks have lending policies which require them to charge different
interest rates to customers depending on the reasons for the borrowing. This is because
some types of lending are more risky than others. Ultimately, it is the bank's discretion
to charge whatever interest rate they choose. For risky ventures, the rate will obviously
be higher. Loan interest might either be fixed or discretionary or floating. With fixed
interest rates, the lending policies of most banks stipulate different rates for different
purposes to customers. For discretionary rates, the bank will decide on the returns which
it requires from the lending. A loan for risky ventures such as a new business would be
offered a higher rate of interest, so as to compensate the bank for the risk it takes that
the lending will not be repaid, than a loan perceived to be of low risk.
4, Purpose of the loan

The purpose of the borrowing affects not only the interest rate but also the bank's
decision as to whether or not to lend in the first place. A bank will not lend money for
an illegal purpose. It will normally lend in order to finance working capital, provided
that the company's liquidity position is still manageable. Lending to finance new
ventures is more risky since many of them fail. The bank will be more cautious in these
cases. The customer must specify the purpose of the borrowing. Loans for certain
purposes will normally not be granted at all. Some will be granted only on certain
conditions.
Illegal Loans: these are loans which are for illegal purposes such as drug smuggling.
Bankers will obviously refuse to grant such loans.
Lending to Finance Working Capital: Recall that working capital is capital used in
the running of the day -to -day transactions of the business. Lending money (usually an
overdraft) to finance some of the working capital of the business is quite normal.
However, when the intended purpose of an advance or credit is to finance a big increase
in the stock holding or debtors, the bank will consider the liquidity of the business and
whether the customer will need more and more financial assistance from the bank as
time goes on.
Loans for New Business Ventures: A loan to set up a new business venture should be
viewed in the context that all new ventures are risky, while many do succeed. A
considerable number of them fail to make profit and will not survive.
5, Amount of the Borrowing

The lending proposition must state exactly how much the customer wants to borrow.
This might seem self-evident, but there are two important points to consider. The banker
will check that the customer is not asking for too much or more than is needed for the
particular purpose. This is especially important with requests for an overdraft facility.
Generally, this consideration is linked in with the customer's wealth and the ability to
repay.
The banker checks that the customer has not asked for less than he or she really needs.
Otherwise, the bank may later have to lend more purely to safeguard the original
amount safeguard.
Generally, the lending policy will indicate limits on the amount of certain loans and the
amount which must be paid "upfront" by the customer.
6, Repayment Terms
The bank must not lend money to a person or company that does not have the ability to
repay it, with interest, irrespective of any security available for the loan. Security should
only be called upon as a last resort if there is a sudden unexpected inability to pay. A
payment term should be realistic. Overdrafts are repayable on demand and are therefore
more risky for the borrower. The likelihood that the advance will be repaid is the most important
requirement for a loan. A bank should not lend money to a person or business that has not got the
resources to repay the loan. Any Item that is pledged by a customer
to secure a loan for the risk of default is called a collateral security. Security for the loan
gives the lender the right to take certain assets if the borrower defaults. Security is only
a safety net, to be called upon only in the event of an unfortunate and unexpected
inability to pay. For debentures, securities can be based on fixed charges or floating
charges. With fixed charges, some particular assets are taken to secure the loans e.g.
land and buildings. On the other hand, debentures can be secured based on floating
charges and with this, all the assets of the business can be taken as securities.
The time-scale for repayment is also vital. Overdrafts are technically repayable on
demand (although it is very rare for a bank to insist on this without first haven't
discussed the different time scales). Other loans might be repayable in instalments,
bullets, balloons, and amortization).
7, Insurance against the Possibility of Non-Repayment
When lending large sums of money to an individual or to a company, the bank may well
ask for the loan to be secured. This security may take the form of title deeds to
property- either property of the company or the individual's house, depending on who is
making the application for finance. A borrower may take out payment protection
insurance, so that his payments are covered even if his financial position deteriorates. If
the bank needs to take insurance against the possibility that the loan will not be repaid -
(in the form of security, such as title deeds or a life policy), then, the_ loan should be
made as stated above, security is only a safety net. Generally, many customers might
take out payment protection insurance for peace of mind.
8, The Greatest Asset of a Customer

In spite of all the tools discussed above, the greatest asset of a customer is mutual trust.
This is not to say that bankers should trust customers, but that customers should trust
each other by accepting to be sureties to other customers. For a customer to act as a
surety to another customer, the customer must be trust wealthy. In this case, s (he) must
have money in her or his account to secure the loan of his chum. The banker will not
allow the surety to withdraw money from the account to below the amount of the loan.
A situation where a customer uses his asset to secure the loan of another, the asset is
called a collateral security. Where a customer uses his asset to secure his own loan, the
asset is called it direct security. Generally, bankers are advised to rely on mutual trust
because, the banker will incur no cost to recover a loan, since the money in the surety's account will
be usurped to pay for the loan •
Stages in Credit Analysis
The credit officer of the bank must acquaint himself with the general policies of the
bank, especially the lending policies, the economic and political environments before
going into analyzing a bank credit. He must be armed with knowledge, avoid temptation
of treating all customers equally for the purpose of credit extension. Each loan
application must be fully examined before the loan request is granted or refused and financial
statement analysis and project evaluation, security evaluation and perfection
and the decision stages.
Collection of Credit information
When a customer comes for a loan, he will not receive the loan on the same day. He
must first. Fill a Loan Application Form (LAF), giving details of him and other
information.
The banker will receive the LAF and may ask the customer to go and come back later.
During this time, the banker will collect the information that will be used to investigate
or carry out a credit rating to evaluate the creditworthiness of the customer. Information
used in credit analysis is from primary and secondary sources. For convenience, they
may be classified into five categories:
- Those that will come from the credit application (borrower) i.e. from the LAF,
- Information from the bank's own records, e.g. financial statements.
- Information from other sources e.g. credit agencies, credit bureau,
- The customer's payment history with the firm.
- Credit reports on the customer's payment history with other firms.
. This information will ensure that the banks laid-down policies and regulatory constraints
are followed. The information collected will help to determine the applicant's character,
condition, capacity, capital and collateral securities.
Credit Investigation and Evaluation
Credit investigation should result in the accumulation of added information about every
factor that affects the loan application. Every information about the loan application is
important and once investigations are made and the validity of such information is
found, the loan officer can stand a better chance of making a right decision, whether to
accept or reject. Credit investigation is an extension of the credit information collection
state and it is difficult to draw a line between the two stages. However, most of the
information gathered will help to confirm the one already collected. There is no definite
route to be followed because each loan application differs in the things to be
investigated. The thing to be investigated depends on the peculiar features of each loan
e.g. to a business customer, the things to be investigated include:
- History of the company
- Experience and the competence of the management.
- Conditions of the company's plans.
- The present financial condition of the company.
We may also look at the company's products and experience in product development
and opinions of other banks about the company.
Banks have developed a way of revealing the performance of the customers through
coded responses to banker's inquiry. The opinions of other banks should however be
used with caution because loan applications normally give the names of the banks
where they have records for banks references.
Opinions of the suppliers should be taken into account, to know if the company pays its
bills promptly.
The opinion of competitors can be taken into account, but be prudent in the use of the
information.
The general business conditions of the customer's industry and the economic conditions
must be investigated. The existing government and prospective regulations as they
affect the industry should be evaluated because they may affect the customer's ability to
repay the loan.
For individuals, investigation is to be carried out as to their character, ability to create
income; possession of assets and the stability of earnings must be examined. Most of
this information needed for credit information is got by visiting the company. In the
collection of such information, there should be a critical assessment of the costs and
benefits of using that information.
Credit evaluation based on the 7Cs
Character
The character of the borrower has two things: the ability to pay and the
willingness to pay. The ability to pay refers to the borrower's financial credibility to
pay. A good character is one that has the ability and a willingness to pay. This is
difficult to evaluate because the character of customers change with time, resources
owned, etc. Character could be inferred from the following: The customer's past
payment records, experience of other lenders with this customer, purpose of the loan,
and customer's track record in forecasting business or personal income credit rating and
the presence of con signers or guarantors of the proposed loan. We can also look at
whether the customer is married and how long he/she has been in the same address.
Capital
It is a measure of a customer's assets. If a credit customer's earnings power
fails, assets can be sold to repay the loan. This may be based on the customer's financial
reserves. It refers to the degree of commitment and the ability to sustain this
commitment during bad times. The gearing level must be evaluated. Look at the
solvency of the company, amount of capital.
Capacity
This refers to the sources of repayment. This is the customer's ability to meet
credit obligations out of operating cash flows and how much the business is
generating. Alternative source of repayment is also vital because some time a serious person can fail
to repay the loan because of genius reason that at times these alternative sources helps. For example
having earning spouse is an added advantage in loan repayment. The higher the capacity the higher
the creditworthiness
Conditions
It is all about the macroeconomic environment. These look at the sector issues, supply risks,
nature of customer relationships and the competitive landscape of the company. Conditions of the
individual credit customer (how well the business is
doing at a given time) and of the economy in general have an important effect on
creditworthiness. Even a well-managed firm may have difficulty to pay its debts on time
when business conditions are very bad. This deals with the general economic conditions
in line with the customer's business. This may be measured in terms of: the customer's
current position in industry and expected market share, the customer's performance vis-
a-vis comparable firms in the same industry, competitive climate for customer's demand
and supply of a product, sensitivity of customer and industry to business cycles and
changes in technology, labour market conditions in customer's industry of market area,
impact of inflation on customer's balance sheet and cash flows, long-term industry or
job outlook, regulations, political and environmental factors affecting the customer
and/or his or her job, business and industry. The GDP, demand and supply of the state
is also important.
Collateral
It is the lender's second line of defence. This is anything of value that a

borrower promises to give the lender if the borrower is unable to repay the loan. A loan
for which collateral is held is said to be a secured loan and that which no security is held
is called an unsecured loan. This is an asset pledged by the customer for security in
case of default. This must be measured in terms of: ownership of assets, vulnerability of
assets to obsolescence, liquidation value of assets, degree of specialisation in assets,
liens, encumbrances and restrictions against property, leases and mortgages issued
against property and equipment, insurance coverage, guarantees and warranties issued
for others, lender's relative position as creditor in placing a claim against borrower's
assets and probable future financing needs. Collateral is the .last option. Banks should
not receive personal houses, schools, hospitals, church etc as collateral for a loan. The
collateral must be 150 of the face value of the loan for depreciation plus related
expenses.
The debilities of the 5Cs are that: they do not look at the purpose of the loan, the
amount of the loan, the experience of the customers, and the margin to be gained on the
loans. This can be measured from: the identity of customer and guarantor, copies of
Social security cards, driver's licenses, corporate charter, resolution, partnership deed,
other legal agreements, description of history, legal structure, owners, and nature of
operations, products, and principal customers and suppliers of a business borrower.
Cash
This shows the adequacy of income or cash flows. This can be measured from:
take-home pay for an individual, past earnings, dividends, and sales records for a
business firm, adequacy of past and projected cash flows, availability of adequate
reserves, turnover of payables, account receivables, inventory, capital structure and
leverage, expense controls, coverage ratios, PIE ratio, management quality and recent accounting
changes. If someone earning is high but the expenses to earn that amount is more than that, then
he became cash deficiency and is not creditworthy because loan is repay with cash
Control
This involves compliance with the lenders loan policy and regulations. This can be measure in
terms of; applicable laws and regulations regarding the character and quality of acceptable loans,
adequate documentation for examiners who
may review the loan, signed acknowledgement and correctly prepared loan documents,
consistency of loan request with lender's written loan policy, and input from non-credit
personnel on external factors affecting loan repayment.
The 5Cs are mostly used to establish the creditworthiness of a borrower. The concept if
correctly applied seeks to evaluate the key criteria for repayment ability, by analysing
the stream of the cash flows, the character of financial discipline, the financial health of
the borrower and other quantitative factors. Different weightings are used for the 5Cs,
as seen below:
Chapter Three:
Security Evaluation
Loans are advanced to a borrower firstly based on the soundness of the business in which the
money is being put and the capability of the borrower to execute or implement the investment
plan and his willingness to meet his obligations. These should be the primary source of security;
however lending institutions need a fall back plan in the event that the borrower fails to execute
the plan. This is why security comes into play. The bank will liquidate the security when the
borrower defaults.
A security is an asset that is pledged to secure a loan, in case of default. If the customer
does not pay the loan, the bank will sell the asset to recovery the loan. The bank may
have the right to retain possession of an asset until the loan is paid (lien). The essence
of evaluating the security is to make sure that it is adequate and that the giver has all the
rights over it as a security. The common securities accepted by the banks are land,
insurance policies, government bonds, guarantees, mortgages, stocks and shares and
debentures. The following are the attributes of a good security:
Characteristics of a good security for a loan
Almost anything that is lawful may be used as collateral, but some things are better than others.
The factors listed below determine the suitability of items for use as good collateral.
Durability
This refers to the ability of the assets to withstand wear, or to its useful life. Durable goods make
better collateral than nondurables. Stated otherwise, crushed rocks make better collateral than
fresh flowers.
Easily marketable
In order for collateral to be of value to the bank, the collateral must be marketable. That is, you
must be able to sell it. Specialized equipment that has limited use is not as marketable as trucks
that have multiple uses.
Price stability
Stability of Value Bankers prefer collateral whose market values are not likely to decline
dramatically during the period of the loan. Common stocks, for example, are not as desirable as
real estate for collateral because stock prices are more variable than real estate prices.
Tangible
Transferable/negotiable
Genuineness of title (free from encumbrance)
Guarantee. At times when the personal security of the borrower is not considered sufficient or
when the risk involved is a border line case and the borrower is not in a position to offer
sufficient collateral to the loan, the bank may ask for a guarantee or surety of a third party whose
financial ability and credit standing is acceptable to the bank. A guarantee is an undertaking
given to the bank by a third party, called the guarantor to be answerable to the bank for the debt
of the borrower upon his default in repayment of the loan. It should be remembered that such
security for the loan depends on the continued solvency of the guarantor. To safeguard the bank’s
interest a continuing guarantee in the bank’s standard form should be obtained
Easy to value: The security should have an identifiable value which is stable or
increasing, and fully covers the lending plus margin. The margin of safety for lending
for lending should be 50. Therefore, the value of the loan should be 100 and that of
security 150 e.g. if a customer wants a loan of 1000,000 FCFA, the value off the collateral
security will be 1,500,000FCFA. .
Easy to realise: an ideal security is one which can easily be sold or converted to cash. It
should be highly liquid and can be easily converted into cash with less risk. Banks
prefer readily realisable securities because, the administrating cost will be kept-at
minimum, there is danger of deterioration between the' time of default and that of
realisation and a quick payoff reduces the length of time over which interest accrues on
the unpaid loan.
The 'security must be able to appreciate over time e.g. land. Generally, conscious
bankers must assess the location of the collateral security. E.g. if a customer presents a
house, the bank should be able to know the location of the house, whether it is in an
accessible area or in a high risk area.
There should be no liability attached to the security and it must not entail heavy
expenses or long formalities on recovery.
Types of Security:
Basically, there are two types of securities available to Banks to secure an Investment/ loan. They
are Primary security and Collateral security.
Primary Security: It refers to the asset directly created out of Bank finance. For example, where
a Bank finances the purchase of a home, the home is the primary security. In the same way, a car
purchased with the help of a Bank Investment/loan is the primary security for that loan. Further in
the case of working capital Investment/loan, “stock and book debts” is considered as primary
security and in case of trading, it is trading stock. Bank creates a charge against this primary
security, to secure its Investment/loan. This charge gives the Bank the legal authority to dispose
of the asset, and apply the proceeds therefrom to the Investment/loan amount in default.
Collateral Security: It refers to certain additional security obtained by the Bank to secure the
Investment/loan. For example, say, a Bank has financed the purchase of rice for trading. This
stock of rice would be the primary security for the Investment/loan. In addition, the Bank may
obtain collateral security in the form of the residential flat owned by the proprietor, as additional
security. This will guard the Bank’s interests in the event of the primary security not having
sufficient value to liquidate the Investment/loan. Sometimes, on account of adverse market
conditions, the value of the primary security gets eroded, exposing the Bank to a higher risk than
it had originally dealt for.
Support (Guarantee): Additionally, Investment/loan can also be secured with the help of
personal security of other individuals/company/ borrower himself. It happens through charging of
guarantor’s Intangible assets (Goodwill), if above two securities fails to cover the exposures.
Margin: In case of non-funded business, i.e payment undertaking on behalf of the client [LC, BG
etc.], the bank usually takes cash in full or part to mitigate the inherent risk; which is called
margin.
Securitization
Banks may raise finance by borrowing from other financial institutions and lending to
other institutions or their customers. Instead of borrowing and lending, they can issue
securities e.g. bonds, debentures, etc, and sell to the public or sold in the security
markets. Securitisation of loans and other assets is the raising of new funds and
reducing exposure. Securitising assets requires a lending institution to set aside a group
of income-earning highly illiquid assets, such as home mortgages and to sell highly
liquid securities against those assets in the open markets. As the borrowing customers
repay the principal and interest owed on their loans, the income will flow to the security
holders. Simply, securitisation involves loans being transformed into publicly traded
securities. It deals with using the security markets to finance a portion of a lender's
loan portfolio, allocate capital more efficiently, diversify sources of finance and
possibly lower the cost of raising finance. The lender whose loans are securitised is
called the originator and those loans are passed on to an issuer, who is usually
designated a special purpose entity (SPE). Loans placed in an income-generating pool
against which securities are issued in order to raise new finance are called securitised
assets. A bank borrows money from investors or savers and lends to borrowers,
charging fees to both for its service as well as making a turn on the interest payments.
Ira borrower can borrow from an investor, by issuing them with a bond or equity, the
costs to both the borrower and lender can be reduced.
Importance of securitisation
- It will lead to the diversification of the lender's credit risks.
- It reduces the need to monitor each individual loan's payment stream
- Securitisation is also a tool for managing interest rate risk. .
- It creates several opportunities for revenue for a lender choosing their fund-raising alternative.
- It creates liquid assets out of what are often illiquid, expensive-to-sell assets and
transforms these assets into new sources of finance for lenders and attractive
investments for investors in the global money and capital markets.
- The cost of borrowing will reduces because of securitisation.
- There is no use of collateral securities and the duration of the redemption of securities will be
certain.
The Red Flags
A red flag is a warning or indicator, suggesting that there is a potential problem or threat with a
bank's assets, financial statements. Red flags may be any undesirable characteristic that stands
out to an analyst or investor. The term red flag is a metaphor. It is generally used as a warning or
a cause for concern that there is a problem with a certain situation.
Loan defaults may eventually lead to non-performing loans (NPLs). NPLs adversely affect
the profitability of the banks as well as endanger their shareholders' funds. To this end,
banks have set up Risk management Departments to monitor credit quality and to take
early preventive actions to control NPLs. One of the methodologies of monitoring
credit quality is to be able to identify early warning signals commonly known as red
flags, or the symptoms of a weakening credit. Some of the red flags can be seen in the
following areas, as seen in the table below:
Chapter Four:
Types of Loan and Loan Repayment
Loan types vary because each loan has a specific intended use. They can vary by length of time,
by how interest rates are calculated, by when payments are due and by a number of other
variables. The exact amount of the loan and interest rate varies depending on your income, debt,
credit history, and a few other factors. There are many different types of loans you can borrow.
Knowing your loan options will help you make better decisions about the type of loan you need
to meet your goals.
Auto Loans
Like mortgages, auto loans are tied to your property. They can help you afford a vehicle, but you
risk losing the car if you miss payments. This type of loan may be distributed by a bank or by the
car dealership directly but you should understand that while loans from the dealership may be
more convenient, they often carry higher interest rates and ultimately cost more overall.
Personal Loans
Personal loans can be used for any personal expenses and don’t have a designated purpose. This
makes them an attractive option for people with outstanding debts, such as credit card debt, who
want to reduce their interest rates by transferring balances. Like other loans, personal loan terms
depend on your credit history.
Mortgages
Mortgages are loans distributed by banks to allow consumers to buy homes they can’t pay for
upfront. A mortgage is tied to your home, meaning you risk foreclosure if you fall behind on
payments. Mortgages have among the lowest interest rates of all loans.
Student Loans
Student loans are offered to college students and their families to help cover the cost of higher
education. There are two main types: federal student loans and private student loans. Federally
funded loans are better, as they typically come with lower interest rates and more borrower-
friendly repayment terms.
Based on the purpose of the loans
It is very vital to know the types of loans that banks and their competitors give out.
They make a wide variety of loans to customers for different purposes. The loans are
divided into seven broad categories by the purposes.
Real Estate Loans: These are loans that are secured by real property: land, buildings,
and other structures and these include short-term loans for the construction and land
development and the longer-term loans to finance the purchase of farmland, homes,
apartments, commercial structures and foreign property.
Financial Institution loans: These include loans to banks, insurance companies,

finance companies and other financial institutions.
Agricultural loans: These are loans extended to farmers to assist in planting and
harvesting crops and supporting the feeding and care of life stock.
Commercial and Industrial Loans
These are loans granted to businesses to cover the purchase of inventories, pay taxes
and wages to employees.
Loans to individuals: These include loans to finance the purchase of automobile,

mobile homes, appliances and other retail goods, to repay and modemise homes and to
covet the cost of medical, educational and other personal expenses.
Lease Finance receivables: These are loans used by lenders to buy equipment or
vehicles and lease them to its customers. The banks receive rentals on these assets. This
is called operating leasing. In some situations, the banks use these to buy assets for the
customers and these assets are used as securities for the loans. This is called finance
leasing. It is a form of mortgage.
Miscellaneous loans: These include some of the loans not listed above including
security loans, school fee loans, etc.
Business loan
There are many different types of business loans that banks and other
financial institutions make. Banks, financial companies and competing business lenders
grant many different types of commercial loans. Business loans are categorized into two
types:
- Short- term business loans
- Long -term business loans
1. Short-term Business Loans
The following short-term business loans can be distinguished:
1.1. Self-Liquidating Business Loan
These loans are usually used to finance the purchase of inventory, that is, raw materials
of finished goods to sell. Such loans rotate within the cash operating cycle. Here, cash is
spent to acquire inventory of raw materials and semi- finished goods or finished goods,
goods are produced for sale, sales are made on credit and some for cash and finally,
cash is received from debtors and it is then used to repay the self- liquidating loans. This
may usually take 30 to 90 days. The operating cycle is the time period for cash outflows
to come in as cash flows.
1.2 Working Capital Loans
Working capital is capital used for the day- to - day running of the business. Working
capital loans are often used to finance the purchase of stock or purchase of raw
materials. It could also be used to pay creditors. The loans are designated to cover
seasonal peaks in the business, customer production levels and credit needs e.g. loans to
purchase books for sale when schools are resuming in September and loans to buy
clothes for sale during Christmas.
1.3 Interim Construction Financing Loans.
These loans assist in the construction of homes, apartments, office building, shopping
centres and other permanent structures. These are used to hire workers, lease
construction equipment, purchase building materials and develop land.
1.4 Security dealer financing
Dealers in securities need short- term loans to purchase new securities and maintain
their existing portfolios of existing securities, until they are sold to customers or reach
maturity. Such loans are of very high quality and are often backed by pledging the
securities as collateral. Related types of loans are extended to investment banking firms
to support their underwriting of new corporate bonds. (Underwriting is a process of
guaranteeing stocks and government debts). These will help their customers finance
mergers, assist in taking company's public and help in launching complete new
ventures. Banks and security firms lend directly to individuals by buying stocks, bonds,
options and other financial instruments.
1.5 Retailer and Equipment Financing
These are loans to support the purchase of automobile, furniture, business equipment, home
appliances and other durable goods. .
1.6 Assets-based Financing
These are loans secured by the short- term assets of the firm that are expected to be
converted into cash in the future. Business assets used for these loans are inventories
and account receivables (debtors). In most loans that are secured by debtors and
inventory, the borrower retains title to the assets pledged but sometimes title is passed to
the lender. The most common arrangement is factoring, where the lender takes on the .
responsibility of collecting the account receivables to his business customers.
1.7 Syndicated Loans
It is a loan package that is extended to a corporation by a group of lenders (banks)

These may arise when a single bank is unable to provide the required amount and also
to reduce the risk of collapse of the bank, if such a large amount given out is not repaid.
Syndicated loans usually help to pool the risk. Many syndicated loans are treated in the
secondary markets.
2. Long-term Business Loans
These are loans that may be repaid greater than one year. They include,
2.1 Term business loans'
These are loans used to finance long-term investments, such as purchase of equipment
and construction of physical facilities. These loans are usually amortized. Usually the
borrowing firm applies for lump-sum based on the budgeted cost of its project and
pledge to repay the loan in a series of monthly, quarterly or yearly instalments. The
schedule of instalment payments is usually structured with the bower's normal cycle of
cash inflows and out flows firmly in mind. The loans are secured by fixed assets (like
plants or equipments) owned by the borrower and may carry fixed or floating interest
rates usually higher than the interest rate of short term loans due to the lender's greater risk
exposure from such loan
2.2 Revolving credit loans
It allows a borrower to borrow up to a pre-specified limit, repay all or a portion of the

borrowing and can re-borrow if necessary until the credit limits matures. It is often
granted without specific collateral and may be short term or a period as long as five
years. It helps' out fluctuations in the business cycle for a firm, allowing it to borrow
extra cash when sales are done and to repay during boom periods when internally
generated cash is abundant.
2.3 Long-term Project Loans
These are the most risky types of loans used in the construction of fixed assets to
generate flow of revenue in the future periods. It is risky in the sense that large amounts
of funds are involved, the project may be delayed, laws' and regulations in the region
may change, interest rates may change etc. they may be granted on a resource basis, in
which the lender can recover funds from the sponsoring companies if the project does
not payout as planned. On the other hand, theloan may be extended on a non-resource
basis, in which there are no sponsor guarantees. The projects stand or fall on their own
merit. Hence, the lender faces significant risks.
2.4 Loans to support the acquisition of other businesses
These are loans used to buy other businesses. These are loans to finance mergers and
acquisition of businesses.
Special Lending Situations
There are special situations in which a banker may be asked to lend and it is appropriate
to consider some of these now.
Fronting Loans
A fronting loan is a loan between a parent and its subsidiary channelled through a
financial intermediary, usually a large international bank. In a fronting loan, the parent
company deposits money in an international bank and the bank lends the same amount
to the foreign subsidiary. A Nigerian bank, DBA, might lend 50 million FRS to a
Cameroonian subsidiary and from the bank's perspective; the loan is risk free because it
has 100 collateral in the form of the parent's deposit. The bank makes profit by
paying the parent company a slightly lower interest rate on deposit than it charges for
foreign subsidiaries on the borrowed funds.
Reasons for Fronting Loans

There are two main reasons for fronting loans:
- Fronting loans can circumvent (to avoid) host country restrictions on the remittance of
funds from a foreign subsidiary to the parent.
- A fronting loan can provide tax advantages, because interest payment will be net of tax.
Bridging Loans: A bridging loan or bridge loan is an agreement by which a bank lends
a person some money for a short-term until that person can get the money from
somewhere else, often so that they can buy another house before they sell their own. It
is simply provided by the bank to a customer as a temporary measure for a very short
period (a few days or weeks) until other expected funds become available. This is loan
sometimes needed by customers moving from one house to another. It involves the bank
advancing the deposit for a new house to the buyer pending receipts of the sales proceeds of the
old house. The first step of a house purchase is that the prospective
buyer agrees to buy "subject to contract". This may involve payment of the deposit
which is returnable should the transaction fall true, but there is no binding contract at
this stage.
Produce Loans: These are loans where goods or produce are taken as securities e.g. cocoa
farmers can take number of bags of cocoa as a security for a loan. The bank must
be certain of the commercial integrity of its customer especially with regard to the
quality and marketability of the goods. The security taken by the bank consists of either
obtaining the document of title for the goods or arranging the goods to a warehouse in
the bank's name.
Revolving loan (credit): It is also called open-end credit. It is a loan from the bank or
~ groups of banks to a company in which the company has flexibility with regard to the
timing and the number of drawdown and repayments; any loan repaid can be re-
borrowed subject to fulfilment of the conditions of the committed facility.
Line of credit or credit line: This is an agreement between the borrower and lender
that loans up to a specific maximum will be extended if needed during a specific period
of time. It is simply an agreement between the bank and the company specifying the
amount of short-term borrowing the bank would make available to the company over a
given period of time. Within the specified limit/line of credit, any number of drawings is
possible to the extent of his requirements. Payments can be made whenever desired
during the period. The interest is determined on the balance or the actual amount
utilised by the borrower and not on the sanctioned limit. However, a minimum charge
may be payable on the unutilised balance irrespective of the level of borrowing for
availing of the facility.
Open-Ended and Closed-Ended Loans
Open-ended loans are a type of credit against which you can borrow over and over. Credit cards
and lines of credit are the most common types of open-ended loans. Both of these have a credit
limit, which is the maximum amount you can borrow at one time.
You can use all or part of your credit limit, depending on your needs. Each time you make a
purchase, your available credit decreases. As you make payments, your available credit increases,
allowing you to use the same credit over and over as long as you abide by the terms.
Closed-ended loans are one-time loans that cannot be borrowed again once they’ve been repaid.
As you make payments on closed-ended loans, the balance of the loan goes down. However, you
don’t have any available credit you can use on closed-ended loans. Instead, if you need to borrow
more money, you have to apply for another loan and go through the approval process over again.
Common types of closed-ended loans include mortgages, auto loans, and student loans.
Secured and Unsecured Loans
Secured loans are loans that rely on an asset as collateral for the loan. In the event of loan default,
the lender can take possession of the asset and use it to cover the loan. Interest rates for secured
loans may be lower than those for unsecured loans because the risk to the lender is lower.
The asset may need to be appraised to confirm its value before you can borrow a secured loan.
The lender may only allow you to borrow up to the value of the asset—or a percentage of its
value. Mortgages are one example of a secured loan, and lenders commonly will only loan up to
80% of the home's value, though there are now many circumstances in which they will lend more
than that amount. A title loan is another example of a secured loan.
Unsecured loans don’t require an asset for collateral. These loans may be more difficult to get
and have higher interest rates. Unsecured loans rely solely on your credit history and your income
to qualify you for the loan. If you default on an unsecured loan, the lender has to exhaust
collection options including debt collectors and a lawsuit to recover the loan.1
Conventional and Nonconventional Loans
When it comes to mortgage loans, the term “conventional loan” is often used. Conventional loans
are those that aren’t insured by a government agency such as the Federal Housing Administration
(FHA), Rural Housing Service (RHS), or the Veterans Administration (VA). Conventional loans
may be conforming, meaning they follow the guidelines set forth by Fannie Mae and Freddie
Mac. Nonconforming loans don’t meet Fannie and Freddie qualifications.
Nonconventional loans, also called government loans, usually have less strict requirements. For
instance, they might let you borrow with less money down, or if your total monthly debt
payments are higher than would be allowed for a conventional loan. They do typically come with
other stipulations, however, such as mortgage insurance
Classification of loan based on the method of repayment
Under this classification, loan can be classified in to interest only loans, pure discount loans and
amortized loans
1, Interest only loans
With interest only loan, borrower is called to pay interest each period and to repay principal at
some time in the future all at once.
NB. If there is only one period, an interest only loan is the same as pure discount loan
2, pure discount loans
With pure discount loan, the borrower receives money today and repay a single lump sum in the
future. This amount will include interest and principal.
Example
Mr. Niba is able to repay 500,000 CFA in 6 years, the interest rate is 8% per annum
How much should the bank lend to him now
3, Amortised loans
This is the most frequently used method of loan repayment in banks and other financial
institutions. It’s a process of reducing a loan by making regular principal reduction. . It is simply
the process by which a debt is reduced by paying small regular
amounts. A very simple way of amortizing a loan is to have the borrower pay the
interest each period plus some fixed amount from principal (called annuity) so that at
the end of the loan period, the loan will be fully paid. This approach is common with
medium-term business loans, car (auto) loans and mortgages.
In this case, we are interested in calculating total annual payments (annuity) and the
principal paid each time (amortised amount). It will be seen that the total payment each
year will decline. The reason is that the loan balance goes down, resulting in a lower
interest charge each year'. To calculate the constant amount that will be paid each year,
we use the formula.
Loan Covenant
A loan covenant is an agreement stipulating the terms and conditions of loan policies between a
borrower and a lender. The agreement gives lenders leeway in providing loan repayments while
still protecting their lending position. Similarly, due to the transparency of the regulations,
borrowers get clear expectations of the terms and conditions of the loan
The loan covenant allows borrowers to prepare for their repayment before and during the
agreement. However, in case a borrower defaults in payment or breaches the covenant, the lender
is entitled to claim the sum of the loan in full. The covenant makes sure that (1) the lenders’
rights are secure, (2) there is a reliable mechanism to rectify the process, and (3) there is a clear
illustration of events leading to the borrower’s default.
Loan default
A loan default happens when a borrower fails to pay his or her loan at the time it is due. The time
a default happens varies, depending on the terms agreed upon by the creditor and the borrower.
Some loans default after missing one payment, while others default only after three or more
payments are missed. in his payments. In such an event, the collateral becomes the property of
the lender to compensate for the unreturned borrowed money. Collateral is an asset or property
that an individual offers to a lender whenever he wants to acquire a loan. It is used as a way to
obtain a loan which, at the same time, acts as a protection for the lender should the borrower
default payment
Lecture note-Loan Portfolio Management
Chapter Five:
Loan Delinquency and Recovery
The lending process does not end when the loan has been given to the customer, but
when the loan has been recovered. Giving out a loan is the soft end of lending while
recovering the loan is the hard end of lending. The customer will always chuckle when
he receives a loan from the bank or any other financial institution, but will usually have
wrinkles or contours on the face, when it comes to repayment. It is a hard nut to crack
for the banks to collect all the loans given out, and as such, some may be defaulted or
will go delinquent. Loan delinquency is a virus in banking as HIV is to the human
system. Bankers need to put in structures and mechanisms to combat this illness (anti -
virus), or else, they will leave their operating scenes. Delinquency is a situation that
arises when the date of payment of a loan passes the due date. A loan is said to be
delinquent when one or more payments (instalments) are passed and were not honoured.
21.2. Causes of Loan Delinquency
Practical research has shown that about 98 of the causes of this illness are internal and
therefore, you can put an end to this illness, to a greater extent, by putting stringent
control mechanisms. We can say that there exist bad lenders and good borrowers. To a
lesser extend, there exists good lenders and bad borrowers. The causes of loan
delinquency can be classified under the following:
21.2.1 Methodology used in Granting Loans
The methods used in granting loans are inappropriate such as the philosophy of granting
loans, loan agreements/contracts are not solved, choice of borrower is not the best, loan
officers do not follow loan policy, loan policy is not adapted to the environment, no
capacity to repay, no willingness to repay, purpose of the loan is diverted, members not
available, tribalism, corruption, favouritism and poor policy and procedures of recovery
which may include:
- Policies and procedures are not clear.
- Directions are not clear.
- There is no systematic recovery, some payments are missed.
- There is no follow up, monitoring and poor evaluation.
- There is an acute lack of financial counselling to know members' problems, existing debts,
etc.
- Lack of education to members on the various loan types, their implications and
advantages.
Economic Situation
Market trends change from time to time, which may change positively or adversely. It is
difficult to forecast what may happen in the future. A loan may be allotted to a customer when
there is no inflation but within the loan period, inflation may step in and off-sets the
repayments. Interest and exchange rates may change in the future.
Political Situation
The political environment has a great role to play in the success of a business. Instability in
the economy may cause rampage and this may lead to the burning, stealing and destruction of
businesses. One of the customers of the bank may have his business destroyed in a political
quagmire
Technological challenges
This is a serious constraint on our financial institutions today. There may be the availability of
computers, but there is no appropriate use of these machines, because of lack of adequate
training. Data that is produced concerning a loan given out may not be on time and the
information link to delinquency is not available.
Environment
It is said that anything that flies in the air must come down; the business environment plays a
vital role in business success. A customer of the bank who does business in a town and one
who does it in the village has different scenes of operation. A banker must know the business
environment of its customers. Generally, most of the delinquency is not caused by bad
borrowers but by the institution which did not put up a good methodology.
The Effects of Delinquency
- Delinquency delays interest collection which is the main source of income and hence, may
cause liquidity problems, a reduction in profits and a decrease in dividends
The cost of fighting delinquency is high.
- It will reduce the interest to be paid to members since the income is not received.
. ~ The financial cost of provisions is high.
- Because more money is outside, it will reduce the viability of the institution.
- It will lead to the reduction in turnover.
- There will be instability in cash flows, cash flows may be erratic.
- It will create difficulties in planning.

- Good members will loss confidence.
- The image (goodwill) of the institution will be doubtful.
- The going concern of the institution is at stake and may result in bankruptcy.
How to Prevent Delinquency
- There should be diversification of loan portfolio per market segment, loan products
and geographical area.
- Create a strategy that does not cause any delay in payment, timely intervention on missed
payments.
- Disbursement on major projects should be in phases (e.g. from foundation to roofing of a

house), to avoid diversion of funds.
- Loan products should be adapted to needs and market segments.
- Financial institutions should use the best asset, called mutual trust (surety-ship).
~ Develop a system to manage, to do efficient analysis on loan portfolios.
- Develop systems that personnel on the field should have quick assess to information.
- Board of directors (BODs) and credit committee should transfer part of their responsibilities
of loan granting, to loan officers.
- Put in mechanisms for motivating customers in order to encourage repayment

recovery. "
- Institutions must have a zero tolerance approach.
- Philosophy aiming at sustainability and viability to financial authority.
- Strike attitude vis- a- vis recovery.
- Penalties, sanctions, recovery of guarantees and legal actions (last resort).
- Monitoring projects from date of disbursement and evaluation to know strength and
weakness.
21.5 How to Manage Delinquency
It should be understood that it is easy to prevent a disease than to cure it. Therefore,
loan delinquency is easy to prevent than cure. The following techniques are used:
- Gather much information on causes of delinquency.
- Put in place an action plan based on the results of diagnosis.
- Slow down lending on those activities that are causing delinquency.

- Continue to grant loans on activities with good performance i.e. give productive loans, self-
liquidating loans.
- Try to separate loan portfolios in two categories, good and bad practices.
- Encourage loan officers that share good attitude to recovery of bad loans.
- There should be a constant update of data of new loans.
- Constant evaluation of performance (reports/results).
- Rescheduling in an appropriate way, loans that have a tendency of repayment.
- Reinforce the basic systems on granting, training equipment and control
- Reinforce control on follow up.
- Write off debts progressively.
- Put square specks in square holes (recruit pedple with some knowledge of the field to
occupy relevant positions, even though they are still human beings).
- Carry out a proper evaluation on the security before giving out a loan.
Loan Recovery and Credit Control
The loan has been granted to the customer and the next issue, is whether the customer will
pay the loan as it was given to him. The banker is supposed to follow the customer up to see
that he pays the loan. This follow up is to stop loan delinquency. It should be understood that
the money borrowed to you is not the bank's money but the public's money and therefore, the
bank has to do anything to recover the money. If it means that somebody should lose his life
after the b•ank has collected the money, there will be no problem. Loan delinquency occurs
when the customer is unable to pay the loan granted. to him. Delinquency is said to occur
when the first instalment is defaulted. Credit control involves the initial investigation of
potential customers and the continuing control of outstanding debts or accounts. When the
customer has finally failed to respect the repayment terms, the banker must develop strategies
to recover the funds.
The following stages will be taken to recover the loan:
Instituting reminders, making calls and site visit: The bank sends out delinquency letters
informing the customer of the past-due status of the account. These should be sent to a named
individual, asking for repayment, a second and a third reminder may be needed, followed by a
final demand, stating clearly the action that will be taken. The aim of this is to goad customers
into action.
The telephone is of a greater nuisance value than a letter, and the greater immediacy can
encourage a response. It may however be time-consuming.
Many fake customers may tell lies that they are not in town, when they are actually behind the
banker. Some may put off their phones permanently. Third world countries will suffer this ill
because the system is undeveloped and technological advancement is remote.
The banker should make personal visits to the customer's business or domicile. This is time-
consuming, and hence, is expensive and tends only to be made to important customers who
are worth the effort.
Renegotiating the terms of the loan: Bankers should be flexible, but not to the
detriment of the bank or the institution. They should be friendly to the customer and
meet the customer for renegotiations. The number of instalments may be increased to
ease the customer's ability to pay and remember that the penalty is that, interest rate will
be increased, as a result. If things go to the worst, tell the customer to pay any amount
that he has at any time.
The bank may employ a collecting agency: This may be a factor and this may be
detrimental to the bank, because the customer's link with the bank may be broken, if the
factor uses a harsh method to collect the debt.
Instituting legal action: This is generally the last option to take. My slogan is that
'business should not go to court'. The banker should critically assess the costs and
benefits.
Generally, costs are usually more than benefits in the less developed nations, because
the legal system is a sham. Premature legal actions may unnecessarily antagonize
important customers and put the system into a business quagmire. My advice is that, the
banker should know his customers and know how to handle them, when they go astray.
Set-off Right
When a customer deposits money into his or her account, the bank's account is debited
and the customer's account is credited.' Based on this, the bank may permit the
customer to draw money from his current account either when there are no funds in the
account, or when there are funds in the account, but are insufficient to accommodate a
cheque. The account will be thrown into a debit (overdraft) immediately the transaction
is done, and the bank becomes the creditor while the customer becomes the debtor. This
situation creates a right in law called set-off. This is the right of a debtor (bank) to take
into account any sum due to him from a creditor (customer) in determining the debt due
to the creditor. Example, assume that Tegwi has a deposit account with NFC Bank. He
deposits 5,000,000Frs into his deposit account and the bank permits him to overdraw his
current account to the tune of 3,000,000Frs. In this case, the bank is the debtor in
respect of the deposit account and a creditor in respect of the overdrawn balance. The
law recognises a right of set- off in the transaction when the following conditions are
satisfied:
The amounts are owed between the same parties: The bank owes the customer in one
account and the customer owes the bank in another account.
The amount owing is definite and ascertainable: Like in the illustration above, the
deposit account is fixed at 5,000,000Frs plus accrued interest and the overdraft is fixed
at 3,000,000Frs and other bank charges.
The amount owing has matured for repayment: The maturity date is due for the deposit
and the overdraft periods have expired.
The rights of the parties inter se on the same amount owing is the same: The deposit is
held in the name of Tegwi in his personal capacity and the bank's recourse for
repayment of the overdraft is on Tegwi in his personal capacity?
The deposit account and the current account must be in the same currency.
Example
Fokou, a customer in UBA deposits 5,000,000 FRS in a deposit account on 1st

January 2012, at the rate of 4 per annum simple interest. The maturity period of the
deposit is 1st December 2014(2 years).
The bank permits Fokou to overdraw his current account and on the 1st January 2013,
Fritz took an overdraft of 2,000,000 FRS at the rate of 1.5 per annum. The overdraft
period is one year. The bank levied charges on the overdraft are 5,000 FRS per month.
After one year, Fokou was not able to meet up with the repayment of the overdraft and
the related expenses. The deposit term and the overdraft period have expired. The
bankers sent letter of set-off to Fokou and this letter was countersigned by Fokou for set-off
agreement.
Chapter Six:
Risks Associated with Lending
Risk is the potential that events, expected or unexpected, may have an adverse impact on the
bank’s earnings or capital.

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Lecture note- loan portfolio management

The principles of good lending, called the canons of lending,

- It should show the lines of responsibilities in making assignments and reporting

Steps Involved in the Lending Process

Evaluation of the customer's character and sincerity of loan purpose: Once a

Credit Rating and Credit Scoring

7Cs = Capital, Condition, Collateral, Character, Capacity, Cash and Control

CAMPARI = Capital, Amount, Margin, Purpose, Ability, Repayment and Interest.

4, Purpose of the loan

5, Amount of the Borrowing

8, The Greatest Asset of a Customer

It is the lender's second line of defence. This is anything of value that a

Characteristics of a good security for a loan

Genuineness of title (free from encumbrance)

- It will lead to the diversification of the lender's credit risks.

- It reduces the need to monitor each individual loan's payment stream

- Securitisation is also a tool for managing interest rate risk. .

- The cost of borrowing will reduces because of securitisation.

The Red Flags

Types of Loan and Loan Repayment

Financial Institution loans: These include loans to banks, insurance companies,

Commercial and Industrial Loans

Loans to individuals: These include loans to finance the purchase of automobile,

- Short- term business loans

- Long -term business loans

1. Short-term Business Loans

The following short-term business loans can be distinguished:

1.1. Self-Liquidating Business Loan

1.2 Working Capital Loans

1.3 Interim Construction Financing Loans.

1.4 Security dealer financing

1.5 Retailer and Equipment Financing

1.6 Assets-based Financing

1.7 Syndicated Loans

It is a loan package that is extended to a corporation by a group of lenders (banks)

2. Long-term Business Loans

2.1 Term business loans'

2.2 Revolving credit loans

It allows a borrower to borrow up to a pre-specified limit, repay all or a portion of the

2.3 Long-term Project Loans

2.4 Loans to support the acquisition of other businesses

Special Lending Situations

Reasons for Fronting Loans

Open-Ended and Closed-Ended Loans

Secured and Unsecured Loans

Conventional and Nonconventional Loans

Classification of loan based on the method of repayment

1, Interest only loans

2, pure discount loans

How much should the bank lend to him now

Loan Delinquency and Recovery

21.2. Causes of Loan Delinquency

21.2.1 Methodology used in Granting Loans

- Policies and procedures are not clear.

- Directions are not clear.

- There is no systematic recovery, some payments are missed.

- There is no follow up, monitoring and poor evaluation.

The Effects of Delinquency

The cost of fighting delinquency is high.