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The bank does not have the luxury of being overly selective in the lending process.
There are a limited supply of quality loans.
Hence the bank has two goals in formulating their lending policy:
The bank must balance these with:
Relative importance of loans, investment securities and cash assets 0% 10% 20% 30% 40% 50% 60% 1935 1941 1947 1953 1959 1965 1971 1977 1983 1989 1995 2001 Percent of Total Assets Cash as a Percent of Total Assets Investment Securities as a Percent of Total Assets Total Loans as a Percent of Total Assets
Noncurrent loans as a percent of total loans 1.74% 1.61% 1.65% 2.11% 1.80% 1.88% 2.31% 2.22% 1.77% 1.16% 0.77% 0.70% 0.64% 0.57% 0.57% 0.58% 0.69% 0.84% 0.00% 0.50% 1.00% 1.50% 2.00% 2.50% Percent of Total Loans 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Although banks have historically been the primary lenders to business, these businesses can obtain loans from many different sources today:
commercial finance companies (AT&T Capital, Commercial Credit, and GE Capital Corporation),
life insurance companies,
commercial paper, and
the issuance of junk bonds.
Reduced regulation, financial innovation, increased consumer awareness, and new technology have made it easier to obtain loans from a variety of sources.
The impact of technology on the bank’s lending market
Lending is not just a matter of making the loan and waiting for payment.
Loans must be monitored and closely supervised to prevent losses.
Technology advances have meant that more loans are becoming “standardized,” hence easier for market participants to offer in direct competition to banks.
Technology, loan standardization and credit scoring
Loans with standard features and uniform loan applications are more easily packaged and sold.
The most commonly securitized loans are those with the most standard features; mortgages, government-guaranteed student loans, small business loans sponsored by the Small Business Administration (SBA), credit card and auto loans.
Loans with standard features can be offered by more market participants, hence these loans often offer the smallest margins.
Many other loans are more difficult to credit score and securitize.
Not all loans can be standardized, credit scored and securitized (sold in marketable packages).
Many farm and small business loans are designed to meet a specific business need.
Repayment schedules and collateral are often customized so that they do not conform to some standard.
Medium to large businesses will have specialized needs as well.
Not surprisingly this is the area of lending that is still dominated by commercial banks and the area in which the bank is uniquely qualified for.
Days accounts payable = AP / Average Daily Purchases where purchases = COGS + Inventory
Days accrual = Accrued exps. / Average Daily Oper Exp.
Estimated Working Capital Needs: = Difference x Average Daily COGS
Seasonal versus permanent working capital needs
Base Amount of W.C.
= Min. Level of Current Assets less min. Level of Current Liabilities, net of short term bank credit and Current Maturities of Long Term Debt (CMLTD).
Some level of current assets / liabilities is required for any business.
The difference in min. levels represents the amount of permanent amount of financing.
Base Amount of W.C. should be financed with Long Term Debt or Equity.
Seasonal W.C. needs
= Total CA - Adjusted Total CL
Trends in working capital needs Dollars Total Current Assets Minimum Current Assets Total Current Liabilities Minimum Current Liabilities Total = Permanent Working Capital Needs + Seasonal Working Capital Needs Permanent Working Capital Needs q Time Seasonal Working Capital Needs Dollars
Short-term commercial loans …Banks try to match credit terms with a borrower’s specific needs.
The loan officer estimates the purpose and amount of the proposed loan, the expected source of repayment, and the value of collateral.
The loan amount, maturity, and repayment schedule are negotiated to coincide with the projections.
Short-term funding needs are financed by short-term loans, while long-term needs are financed by term loans with longer maturities.
Seasonal working capital loans. …finance a temporary increase in net current assets above the permanent requirement
A borrower uses the proceeds to purchase raw materials and build up inventories of finished goods in anticipation of later sales.
Trade credit also increases but by a smaller amount.
Funding requirements persist as the borrower sells the inventory on credit and accounts receivables remain outstanding.
The loan declines as the borrower collects on the receivables and stops accumulating inventory.
Seasonal working capital loans. …t his type of loan is seasonal if the need arises on a regular basis and if the cycle completes itself within one year
It is self-liquidating in the sense that repayment derives from sales of the finished goods that are financed.
Because the loan proceeds finance an increase in inventories and receivables, banks try to secure the loan with these assets.
Seasonal working capital loans are often unsecured because the risk to the lender is relatively low.
Open credit lines …seasonal loans often take the form of open credit lines.
Under these arrangements, the bank makes a certain amount of funds available to a borrower for a set period of time.
The customer determines the timing of actual borrowings, or “takedowns.’’
Typically, borrowing gradually increases with the inventory buildup, then declines with the collection of receivables.
The bank likes to see the loan fully repaid at least once during each year.
This confirms that the needs are truly seasonal.
Asset-based loans. …In theory, any loan secured by a company’s assets is an asset-based loan.
One very popular type of asset-based short-term loan would be those secured by inventories or accounts receivable.
In the case of inventory loans, the security consists of raw materials, goods in process, and finished products.
The value of the inventory depends on the marketability of each component if the borrower goes out of business.
Banks will lend from 40 to 60 percent against raw materials that are common among businesses and finished goods that are marketable, and nothing against unfinished inventory.
With receivables, the security consists of paper assets that presumably represent sales.
The quality of the collateral depends on the borrower’s integrity in reporting actual sales and the credibility of billings.
Loans to finance leveraged buyouts are also classified in this category.
Term commercial loans, which have an original maturity of more than one year, are normally used for credit needs that persist beyond one year.
Most term loans have maturities from one to seven years and are granted to finance either the purchase of depreciable assets, start-up costs for a new venture, or a permanent increase in the level of working capital.
Because repayment comes over several years, lenders focus more on the borrower’s periodic income and cash flow rather than the balance sheet.
Term loans often require collateral, but this represents a secondary source of repayment in case the borrower defaults.
Revolving credits …Revolving credits are a hybrid of short-term working capital loans and term loans.
They often involve a commitment of funds (the borrowing base) for one to five years.
At the end of some interim period, the outstanding principal converts to a term loan.
During the interim period, the borrower determines usage much like a credit line.
Mandatory principal payments begin once the commitment converts to a term loan.
The revolver has a fixed maturity and often requires the borrower to pay a fee at the time of conversion to a term loan.
Revolvers have often substituted for commercial paper or corporate bond issues.
Nonmortgage consumer loans differ substantially from commercial loans.
Their usual purpose is to finance the purchase of durable goods, although many individuals borrow to finance education, medical care, and other expenses.
The average loan to each borrower is relatively small.
Most loans have maturities from one to four years, are repaid in installments, and carry fixed interest rates.
In general, an individual borrower’s default risk is greater than a commercial customer’s. Consumer loan rates are thus higher to compensate for the greater losses.
Consumer loans are normally classified as either installment, credit card, or noninstallment credit.
Installment loans require a partial payment of principal plus interest periodically until maturity.
Other consumer loans require either a single payment of all interest plus principal or a gradual repayment at the borrower’s discretion, as with a credit line.
Banks’ share of the consumer credit market has fallen over time, but even with many competitors, commercial banks held around 38 percent of the total credit outstanding in the late 1990s and were the largest single holders of automobile loans, mobile home loans, and all other types.
Venture capital …a broad term use to describe funding acquired in the earlier stages of a firm’s economic life.
Due to the high leverage and risk involved, as well as regulatory requirements, banks generally do not participate directly in venture capital deals.
Some banks, however, do have subsidiaries that finance certain types of equity participations and venture capital deals, but their participation is limited.
This type of funding is usually acquired during the period in which the company is growing faster than its ability to generate internal financing and before the company has achieved the size needed to be efficient.
VC firms attempt to add value to the firm without taking majority control.
Often, VC firms not only provide financing but experience, expertise, contacts, and advice when required.
There are many types of venture financing.
Early stages of financing come in the form seed or start-up capital.
These are highly levered transactions in which the VC firm will lend money for a percentage stake in the firm.
Rarely, if ever, do banks participate as VCs at this stage.
Later-stage development capital takes the form of expansion and replacement financing , recapitalization or turnaround financing, buy-out or buy-in financing , and even mezzanine financing .
Banks do participate in these rounds of financing, but if the company is overleveraged at the onset, the banks will be effectively excluded from these later rounds of financing.