Traditional Commercial Bank Lending Products
Short-term loans, those with maturities of one year or less, comprise more than half of all commercial bank loans made. Seasonal lines of credit and special purpose loans are the most common short-term credit facilities. Their primary use is to finance working capital needs resulting from temporary build-ups of inventory and receivables.
Long-term loans ("term loans") are relatively new in banking practice. Providing advantages in its flexibility to adapt to a borrower's special requirements, a term loan has the following characteristics:
· Original maturity of longer than one year;
· Repayment provided from future earnings or cash flow rather than the short-term liquidation of assets; and
· Provisions of the loan arrangement detailed in and governed by a signed agreement between the borrower and the lender(s), referred to herein as a Loan Agreement.
The revolving credit loan, a variation on the line of credit, has a commitment period often extending beyond one year, up to three or four years
, and allows a business to borrow from a bank up to a maximum commitment level at any time over the life of a credit.
Role of the Loan Officer
The loan officer must balance two often conflicting responsibilities: those of a marketing officer and those of a credit officer. While budget pressures require the loan officer to develop new banking relationships, credit responsibilities require that these new relationships do not sacrifice credit quality for short-term profits. The lending institution and its shareholders expect loan officers to understand a credit thoroughly before initialing their approval to lend the bank's capital. Every commitment of a lending institution typically requires independent approval and the signatures of at least two senior lending officers, who are held directly accountable for the lending decision.
Before a bank agrees to commit its funds to a company, its loan officers have a responsibility to evaluate a borrower's ability and willingness to repay a loan at maturity.
A thorough financial analysis requires preparation of the following:
1. Year-to-year comparisons of financial statements
2. Cash-flow statements
3. Liquidity analysis
4. Capital structure analysis
5. Projections and sensitivity analysis
6. Estimation of asset values
7. Comparison of actual versus budgeted performance
Pro forma financial and operating statements are prepared so the lending officer can assess the borrower's potential to generate sufficient free cash flow to make interest and principal payments when due. These projections and the underlying assumptions must be tested under various scenarios to establish the borrower's sensitivity to change.
Credit evaluation also requires assessment of the character and capabilities of the persons to whom a loan may be extended, i.e., the persons responsible for achieving the goals of the operating and financial plans. Lenders must determine the quality, breadth, and depth of the management team. Assessing their ability to implement operating and financial plans will give the lender insight into the management team's capability.
Due diligence is the process of going out and "kicking the tires" of the potential borrower. While time consuming, it is an important aid to understanding better how the prospective borrower does business. Due diligence can include plant tours, trade checks, and interviews with the borrower's competitors, suppliers, customers, and employees. Comprehensive due diligence also includes reviews of employee relations, compensation and benefits, management's planned capital expenditures, other debt obligations, and management information systems and technology.
Risk assessment is another component of the credit evaluation process. The credit officer must identify and analyze the key risks associated with a specific credit. Some risks are associated with the borrower and his or her business; other risks are associated with potential changes in the environment, cyclical activity, regulations, or other unanticipated developments. The loan officer must make judgments about future conditions that could affect a borrower's willingness and ability to repay the obligation.
Determining the Bank's Willingness and Ability to Lend
In addition to a thorough credit evaluation, the loan officer must determine whether approving a loan application is in the bank's best interests and within regulatory capital and operating guidelines. A bank's ability to lend is restricted by banking regulations that limit the amount of loans that may be extended to any one borrower. A bank may also establish an internal limit ("house limit") on the amount lent to a single borrower. What influences a bank's willingness to lend are its earnings targets and portfolio objectives. A bank will try to maintain diversification in its portfolio of loans and investments to reduce its exposure to risk. These targets and objectives will shape a bank's loan origination and acquisition strategy. Thus a potential borrower must not only meet the lending institution's credit standards but also be within its target lending market and legal lending capacity.
Structuring the Credit Facility and Loan Agreement
Typically, short-term loans are not made pursuant to a loan agreement, or if so, the loan agreement is far less comprehensive than that used for long-term or revolving loans.
This first section of a standard loan agreement describes how much and when the borrower may borrow, the interest provisions, repayment terms and additional fees, the intended use of loan proceeds
, and any security interest taken by the bank.
The conditions precedent is requirements the borrower must satisfy before the bank has a legal obligation to fund a commitment. These conditions may include any business transactions that must be completed or events that must have occurred. Other standard items in this section are the opinions of counsel, certificate of no defaults, the note
, and resolutions of the borrower's board of directors authorizing the transaction. The conditions precedent will also include a material adverse change clause encompassing both balance sheet condition and operations (income statement and prospects). This clause serves an important protective function for the lender in the case that a material adverse change occurs prior to funding and is not yet reflected in the financial statements.
Representations and Warranties
In considering a loan application, the lender relies on certain information furnished by the borrower and has thereupon made assumptions about the borrower's legal status, creditworthiness, and business position. It is upon these assumptions that the bank has agreed to lend money to the borrower. The representations and warranties section documents the information and assumptions relied upon. By executing the loan agreement, the borrower confirms the accuracy and truth of the information provided as of the date of execution.
Covenants of the Borrower
Covenants are a heavily negotiated part of loan agreements. As representations and warranties verify certain statements by the borrower at the date of execution of the loan agreement, covenants carry forward the representations and warranties and establish the borrower's ongoing obligation to maintain a certain status for the loan's duration. Covenants set minimum standards for a borrower's future conduct and performance and thereby reduce the risk that the loan will not be repaid. Violation of a covenant creates an event of default and gives the bank the right to refuse to make additional advances.
The events of default section describes circumstances in which the bank has the right to terminate the lending relationship.
Sale of Loans to Third Parties
There are several vehicles that facilitate the sale of loans, some of which allow an originating bank to maintain partial ownership of the loan and/or responsibility for its management. Participations, syndications, and asset sales are all examples of underwriting activities undertaken by banks.
A participation loan is a single loan made to a large borrower by more than one lender. Participation loans are made when the lead lender cannot lend to a large borrower because of legal or internal lending limits restricting the amount of bank capital that can be loaned to one borrower or classification of borrowers. The lead bank originates the transaction and maintains responsibility for servicing the loan.
Syndications are similar to loan participations, except that the syndicate members lend directly to the borrower. An originating bank, called the lead bank or manager, arranges a credit facility for a large borrower. The bank then sells off portions of the loan to other lenders.
A relatively recent development has been the sale of loans to third parties. An asset or loan sale is similar to a syndicate except that the lead bank initially takes the credit on its books and then sells off most or all of the credit, retaining little or nothing for its own portfolio. In this transaction all risk, from the sold portion, is eliminated for the originating bank, and the loan is removed from its balance sheet. The bank earns a fee for its efforts in originating the loan.