Chapter 16 Lending Policies and Procedures: Managing Credit Risk



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Chapter 16

Lending Policies and Procedures: Managing Credit Risk




Fill in the Blank Questions


1. The______________ is a uniform rating system developed by regulators where banks are given a rating from one to five in each of six categories and an overall rating from one to five.

Answer: CAMELS
2. One of the 6 C’s of lending,______________ suggests that the lender must look at the position of the business firm in the industry and the outlook of the industry to evaluate a loan.

Answer: condition


3. One of the 6 C’s of lending,______________ suggests that the lender must look to see if the borrower is legally entitled to sign a binding loan agreement. For an individual this entails making sure the borrower is of legal age to sign a contract.

Answer: capacity


4. When a bank purchases a whole loan or a piece of a loan from another bank they are purchasing what is known as a____________________________.

Answer: participation


5. Loans that have minor weaknesses because the bank has not followed its written loan policy or which have missing documentation are called______________ by regulators.

Answer: criticized


6. ____________________________ are loans extended to farmers and ranchers to assist in planting crops, harvesting crops and to support the feeding and care of livestock.

Answer: Agriculture loans


7. ____________________________ devote the bulk of their credit portfolio to large-denomination loans to corporations and other businesses and tend to be large banks.

Answer: Wholesale lenders


8. ____________________________ are loans which are secured by land buildings and other structures. These loans can be short term construction loans or longer term loans to finance the purchase of homes and apartments among others.

Answer: Real estate loans


9. A______________ is signed by the borrower and indicates the principal amount of the loan, the interest rate on the loan and the terms under which repayment must take place.

Answer: Promissory note

10. ____________________________ are those things a borrower must do. They are actions the borrower must take. Examples include filing periodic financial statements with the bank and purchasing insurance on any collateral pledged.

Answer: Affirmative covenants


11. ___________________________ are when lenders extend credit to banks, insurance companies, and finance companies among others.

Answer: Financial institution loans


12. ______________ are loans that carry a strong probability of loss to the bank.

Answer: Doubtful loans

13. A(n)______________ is the process of resolving a troubled loan so the bank can recover its funds.

Answer: loan workout


14. ______________ is one of the key features of any loan. This C of lending examines whether the borrower will have enough sales or income to repay the loan.

Answer: cash


15. A bank’s__________________________________________ gives loan officers specific guidelines in making individual loan decisions and in shaping the overall loan portfolio.

Answer: written loan policy


16. An approach in which the lending officer focuses on changes in borrower cash flows over time is known as the _____________ cash flow method.

Answer: direct




  1. are loans granted to businesses to cover purchases of inventory, paying taxes and meeting payrolls.

Answer: Commercial and industrial loans (C&I Loans)


  1. include credit to finance the purchase of automobiles, mobile homes, appliances and other retail goods and many other purchases by consumers.

Answer: Loans to individuals (consumer loans)


  1. is where the lender buys equipment or vehicles and rents them to its customers.

Answer: Lease financing receivables


  1. Smaller banks tend to emphasize in the form of smaller denomination personal cash loans and home mortgage loans to extended to individuals and families as well as smaller business loans.

Answer: retail credit


  1. The loan mix of any lending institution depends heavily on the that each loan offers compared to all other assets the lending institution can acquire.

Answer: expected yield


  1. Under the no individual can be denied credit because of race, sex, religious affiliation, age or receipt of public assistance.

Answer: Equal Credit Opportunity Act (1974)


  1. One aspect of the CAMELS rating system is which looks at the quality of the bank’s loans. Examiners look at all loans over a certain size and a random selection of all other loans when looking at this aspect of a bank.

Answer: asset quality


  1. One part of the 6 C’s of lending is which looks at whether the borrower has a well-defined purpose for the loan and a serious intent to repay the loan.

Answer: character


  1. One of the most widely consulted sources of data on business firms is which was founded in Philadelphia in 1914 to exchange credit information among business lending institutions and to organize conferences and publish educational materials to train loan officers and credit analysts.

Answer: Risk Management Associates (RMA)

  1. One problem with the newer lending model called _________________ was found to at least partially contribute to the recent crisis in the mortgage market.

Answer: “Streamlining”

  1. In the mortgage environment of the early 2000s, lenders were encouraged to sell individual loans and packages of loans to buy more liquid securities instead, thus shifting much of the risk of lending to capital markets. This process is referred to as __________________.

Answer: Securitization

  1. Factors such as changes in the economy, natural disasters, and regulation are referred to as __________ factors, while management errors, illegal manipulation, and ineffective lending policies are considered ___________ factors.

Answer: External; internal

  1. In the loan workout process, the preferred option is nearly always to seek a _______________, which gives both the lending institution and its customer the chance to restore normal operations.

Answer: Revised loan agreement

True/False Questions


T F 30. The principal reason banks are chartered by federal and state governments is to make loans to their customers.

Answer: True

T F 31. Risk in banking tends to be concentrated in a bank’s loan portfolio.

Answer: True

T F 32. The largest banks have, on average, reduced their dependence on real estate loans relative to smaller banks.

Answer: True
T F 33. Real estate lending is popular with bank, in part, due to the growth of the secondary mortgage market.

Answer: True

T F 34. Banks in the United States are, on average, examined at least once every three years.

Answer: True

T F 35. Smaller banks tend to emphasize wholesale banking services.

Answer: False

T F 36. Retail credit in banking refers to such loans as residential mortgages and installment loans to individuals.

Answer: True

T F 37. Loans made by a particular bank secured by the bank’s own stock are not usually permitted except under special circumstances.

Answer: True

T F 38. Federally-supervised banks in the U.S. must make an “affirmative effort” to provide loans and other services to all credit-worthy borrowers in their chosen service area.

Answer: True

T F 39. Loans to minors are not legally enforceable contracts in most states.

Answer: True

T F 40. The letter “C” in the CAMELS rating system for banks in the U.S. refers to the “condition” of a bank.

Answer: False

T F 41. The letter “M” in the CAMELS rating system for banks in the U.S. refers to the “management quality” of a bank.

Answer: True

T F 42. The process of loan review means that a loan committee must generally approve a loan before the borrower is told the loan is approved.

Answer: False

T F 43. Troubled loans normally are subject to more frequent review than are sound loans.

Answer: True

T F 44. Credit card loans are generally more profitable for small and medium-size banks than for the largest banks.

Answer: False

T F 45. Banks should concentrate their lending on those loans in which they have the greatest cost advantage.

Answer: True

T F 46. The type of bank loan experiencing the largest losses per dollar of loan is credit card loans.

Answer: True

T F 47. Construction loans by a bank fit under the loan category known as commercial and industrial loans.

Answer: False

T F 48. If the economy slows down a bank should review its outstanding loans more frequently.

Answer: True

T F 49. Foreclosure on property pledged behind a bank loan does not subject a bank to liability to clean up any environmental damage the borrower may have caused to happen.

Answer: False

T F 50. Loans granted to businesses appear to convey positive information to the market place about a borrower’s credit quality, enabling a borrower to obtain more and cheaper funds from other sources.

Answer: True

T F 51. Loans to a bank’s officers can never exceed 2.5 percent of a bank’s capital and unimpaired surplus or $25,000 whichever is larger and cannot be more than $100,000.

Answer: True

T F 52. Financial institutions that disagree with examiner classifications of their loans can appeal these examiner ratings.

Answer: True

T F 53. A rating of “5” is the highest and best rating that a U.S. bank can receive under the CAMEL rating system.

Answer: False

T F 54. Accounts receivable financing means that a bank actually takes over ownership of receivables, whereas factoring means that a bank merely lends money on a borrowing customer’s receivables and the customer still has ownership of the receivables.

Answer: False

T F 55. A restriction against a borrower taking on new debt is an affirmative covenant in a loan contract.

Answer: False

T F 56. Loan review is considered to be a luxury, not a necessity for most banks, especially those with sound lending policies.

Answer: False

T F 57. Cash is one of the 6 C’s of lending and refers to the fact that the lender wants to make sure the borrower has the ability to generate enough cash to repay the loan.

Answer: True

T F 58. There are three principal sources of cash to repay a loan. These are cash flows generated from sales or income, funds generated from the liquidation of assets and funds raised by selling debt or equity securities.

Answer: True

T F 59. Negative covenants require the borrower to take certain actions.

Answer: False

T F 60. Affirmative covenants restrict a borrower from doing certain things.

Answer: False

T F 61. For ease and convenience most banks have the loan review conducted by the same person who makes the loan. This is particularly true of large banks.

Answer: False

T F 62. A loan workout is when the bank and the customer initially negotiate the terms of the loan.

Answer: False

T F 63. A written loan policy gives loan officers and the bank’s management specific guidelines in making individual loan decisions and in forming the bank’s loan portfolio.

Answer: True

T F 64. Commercial and industrial loans are loans to businesses to cover such things as purchasing inventory, paying taxes and meeting payroll expenses.

Answer: True

T F 65. Agriculture loans are loans that are made to individuals to finance vacations, purchase durable goods and other retail goods.

Answer: False

T F 66. The A in the CAMELS rating system stands for asset quality.

Answer: True

T F 67. Net cash flow from operations is the borrower’s net income expressed in cash rather than on an accrual basis.

Answer: True

T F 68. The “direct cash flow” method and “cash flow by origin” are two very different ways of assessing the cash flows of a potential borrower.

Answer: False

T F 69. Commercial banks are the largest originator of household loans.

Answer: True

T F 70. Following the recent global credit crisis, regulators have begun to emphasize the need for loan originators to know their borrowers better and retain some of the risk on loans that they sell.

Answer: True




Multiple Choice Questions




  1. The principal economic function of banks is to:

A) Take deposits

B) Make loans

C) Sell financial services

D) Encourage spending

E) None of the above

Answer: B




  1. Loans extended to finance the purchase of automobiles, mobile homes, home appliances, and vacations are classified as:

A) Real estate loans

B) Financial institutions

C) Agricultural loans

D) Commercial and industrial loans

E) None of the above

Answer: E




  1. According to the textbook the largest category (by dollar volume) of loans extended by U.S. banks is:

A) Real estate loans

B) Financial institutions

C) Agricultural loans

D) Commercial and industrial loans

E) None of the above

Answer: A




  1. Banks that emphasize lending to commercial customers are labeled:

  1. Wholesale banks

  2. Retail banks

  3. Personal banks

  4. Nonbank banks

  5. Regional banks

Answer: A


  1. The vast majority of FDIC-insured institutions are classified as:

  1. Credit card banks

  2. Agricultural banks

  3. Consumer lenders

  4. Commercial lenders

  5. Mortgage lenders

Answer: D


  1. In the United States national banks cannot extend an unsecured loan to a single borrower that exceeds of a national bank’s capital and surplus. The correct figure that fills in the blank in the preceding sentence is:

A) 25 percent

B) 10 percent

C) 15 percent

D) 20 percent

E) None of the above

Answer: C




  1. Real estate loans made by national banks in the U.S. cannot exceed:

A) 15 percent of a national bank’s total assets or 25 percent of its total capital.

B) A national bank’s total capital and surplus or 70 percent of time and savings deposits, whichever is greater.

C) 20 percent of a national bank’s capital and surplus or 80 percent of its savings deposits, whichever is smaller in amount.

D) 25 percent of capital or 10 percent of the core deposits of a national bank, whichever gives the largest amount.

E) None of the above.

Answer: B




  1. Loans to finance one-to-four family homes fall under which loan category?

A) Commercial and industrial loans

B) Real estate loans

C) Loans to individuals

D) Single-payment loans

E) None of the above.

Answer: B




  1. The loan category experiencing the largest losses (loan defaults) is usually:

A) Credit card loans

B) Real estate loans

C) Agricultural loans

D) Commercial and industrial loans

E) None of the above

Answer: A



  1. The most costly type of loan to make (measured by the cost per dollar of loan) for a bank is usually:

A) Real estate loans

B) Agricultural loans

C) Commercial and industrial loans

D) Loans to financial institutions

E) None of the above.

Answer: E




  1. Loans providing credit to finance the purchase of automobiles, mobile homes, appliances, and other retail goods to repair and modernize homes are classified under the category:

A) Financial institution loans

B) Commercial industrial

C) Loans to individuals

D) Miscellaneous loans

E) None of the above

Answer: C




  1. Loans extended to farm and ranch operations to assist in planting and harvesting crops and to support the feeding and care of livestock are known as:

A) Real estate loans

B) Commercial and industrial loans

C) Land loans

D) Agricultural loans

E) None of the above.

Answer: D




  1. Loans granted to businesses to cover such expenses as purchasing inventories, paying taxes, and meeting payrolls are known as:

A) Commercial and industrial loans

B) Agricultural loans

C) Real estate loans

D) Loans to individuals

E) None of the above.

Answer: A




  1. A lender that makes a loan to a minor would be violating which of the 6 C’s of lending?

A) Character

B) Capacity

C) Cash

D) Control

E) Collateral

Answer: B




  1. A lender that makes a loan that violates its written loan policy would be violating which of the 6 C’s of lending?

A) Character

B) Capacity

C) Cash

D) Control

E) Collateral

Answer: D





  1. Which of the following is a factor in determining the mix of loans that a bank has?

A) The location of the bank

B) The size of the bank

C) The written loan policy of the bank

D) The experience and expertise of the management

E) All of the above are factors in determining the mix of loans

Answer: E




  1. A loan to a local business to purchase a new machine would be categorized as:

A) A consumer loan

B) An agriculture loan

C) A commercial and industrial loan

D) A real estate loan

E) None of the above

Answer: C




  1. The lender's secondary source of repayment in case of default is:

  1. Capacity.

  2. Collateral.

  3. Character.

  4. Capital.

  5. Credit.

Answer: B



  1. A lender that makes a loan to an individual whose only income is commission based and who hasn’t made a sale in six weeks may be violating which of the 6 C’s of lending?

A) Character

B) Capacity

C) Cash

D) Control

E) Collateral

Answer: C




  1. Sean Carter has an excellent credit rating. Which of the 6 C’s of lending would this piece of information belong to?

A) Character

B) Capacity

C) Cash

D) Collateral

E) Conditions

Answer: A




  1. First National Bank of Edmond asks a prospective customer for her driver’s license. Which of the 6 C’s of lending would this piece of information belong to?

A) Character

B) Capacity

C) Cash

D) Collateral

E) Conditions

Answer: B




  1. The loan officer of Second National Bank of Laramie decides to review the insurance coverage of one of its business customers. Which of the 6 C’s of lending would this piece of information belong to?

A) Character

B) Capacity

C) Cash

D) Collateral

E) Conditions

Answer: D




  1. The TRC Company is required by its bank to pay no dividend over $3 per share. What is this?

A) An affirmative covenant

B) A negative covenant

C) A Special covenant

D) A horizontal covenant

E) None of the above

Answer: B




  1. A bank that primarily makes its loans to individuals, families and small businesses is:

A) A retail bank

B) A wholesale lender

C) A money center bank

D) A money market bank

E) None of the above

Answer: A




  1. The process of resolving a troubled loan so the lender can recover its funds is called the:

A) Loan Review

B) Written Loan Policy

C) Loan Workout

D) Loan Commitment Agreement

E) None of the above

Answer: C




  1. Which of the following is a sign of a potential loan problem?

A) Timely receipt of financial statements from the company with a loan

B) Increases in the stock price of the company that has a loan

C) Increases in earnings for each of the last three years of a company

D) Changes in the methods used to account for inventory, depreciation and other items

E) All of the above are signs of problems with the loan

Answer: D





  1. Which of the following should be part of the written loan policy?

A) Lending authority of each loan officer and loan committee

B) Lines of responsibility for finding and reporting information within the loan department

C) A statement of quality standards for all loans

D) A statement for the preferred upper limit for total loans outstanding

E) All of the above should be part of the written loan policy

Answer: E




  1. A lender reviews the partnership agreement of one of its small business customers. Which of the 6 C’s of lending would this piece of information belong to?

A) Character

B) Capacity

C) Cash

D) Collateral

E) Conditions

Answer: B




  1. Which act requires that bank loans to insiders be priced at market?

A) Community Reinvestment Act of 1977

B) Equal Credit Opportunity Act of 1974

C) Sarbanes-Oxley Act of 2002

D) Bank Lending Act of 2003

E) U.S. Patriot Act

Answer: C




  1. A method whereby the loan officer focuses on how the borrower cash flows may change over time is known as:

A) Indirect cash flow

B) Direct cash flow

C) Pervasive cash flow

D) Variable cash flow

E) Total cash flow

Answer: B




  1. The South Carolina National Bank makes a loan to the Heritage Credit Union. What type of loan did this bank make?

A) Financial institution loan

B) Commercial and industrial loan

C) Loans to individuals

D) Miscellaneous loans

E) Lease financing receivables

Answer: A




  1. A loan for Colin Beverly to purchase a new Mazda Miata would fit into which of the following categories of bank loans?

A) Financial institution loan

B) Commercial and industrial loan

C) Loan to an Individual

D) Miscellaneous loan

E) Lease financing receivables

Answer: C





  1. The Price Bank of Edmond makes a loan to Home Depot. What type of loan has this bank made?

A) Financial institution loan

B) Commercial and industrial loan

C) Loan to an individual

D) Miscellaneous loan

E) Lease financing receivables

Answer: B





  1. The First State Bank of Duncan buys railroad cars and rents them to the Santa Fe Railroad Company. What type of loan has this bank made?

A) Financial institution loan

B) Commercial and industrial loan

C) Loan to an individual

D) Miscellaneous loan

E) Lease financing receivables

Answer: E





  1. The Third National Bank of Wichita makes a loan so that Tim Bridges can buy 1000 shares of Coca Cola stock. Which category of loans would this loan fit in best?

A) Financial institution loan

B) Commercial and industrial loan

C) Loan to an individual

D) Miscellaneous loan

E) Lease financing receivables

Answer: D





  1. The First State Bank is located in Guyman, Oklahoma which is in the middle of the wheat country of Oklahoma and as a result many of its loans are agriculture loans. What factor determining the growth and mixture of loans does this fact reflect?

A) Characteristics of the market area

B) Lender size

C) The experience and expertise of management

D) The written loan policy of the bank

E) Bank regulations

Answer: A




  1. The Second State Bank has less than $100 million in assets and as a result primarily makes real estate loans, other consumer loans and loans to very small businesses. What factor determining the growth and mixture of loans does this fact reflect?

A) Characteristics of the market area

B) Lender size

C) The experience and expertise of management

D) The written loan policy of the bank

E) Bank regulations

Answer: B





  1. Geoff Willis and Mary Williams the president and CEO of the First National Bank of Edmond both come from a background of retail banking. As a result they have decided to focus their lending activities on consumer loans and loans to small business. What factor determining the growth and mixture of loans does this fact reflect?

A) Characteristics of the market area

B) Lender size

C) The experience and expertise of management

D) The written loan policy of the bank

E) Bank regulations

Answer: C





  1. First State Bank’s loan policy manual states ‘that the goal of the bank is to make high quality loans for home mortgages, the purchase of automobiles and small business accounts receivables’. What factor determining the growth and mixture of loans does this fact reflect?

A) Characteristics of the market area

B) Lender Size

C) The experience and expertise of management

D) The written loan policy of the bank

E) Bank regulations

Answer: D





  1. The Second National Bank has capital and surplus of $100 million. The bank has decided that the most that it can loan to the Krumlova Manufacturing Company is $15 million. What factor determining the growth and mixture of loans does this most likely reflect for this bank?

A) Characteristics of the market area

B) Lender size

C) The experience and expertise of management

D) The written loan policy of the bank

E) Bank regulations

Answer: E





  1. A loan that appears to examiners to contain significant weaknesses or that represent a dangerous concentration of credit in one borrower or industry are called:

A) Criticized loans

B) Scheduled loans

C) Substandard loans

D) Doubtful loans

E) Loss loans

Answer: B





  1. A loan that examiners regard as uncollectible and unsuitable to be called a bank asset is called a:

A) Criticized loan

B) Scheduled loan

C) Substandard loan

D) Doubtful loan

E) Loss loan

Answer: E





  1. The law that requires banks to make ‘an affirmative effort’ to meet the credit needs of individuals and businesses in their trade territories is called:

A) The Sarbanes-Oxley Act

B) The Community Reinvestment Act

C) The Equal Credit Opportunity Act

D) The Truth in Lending Act

E) None of the above

Answer: B





  1. The law that prevents individuals from being denied credit because of race, sex, religious affiliation, age or receipt of public assistance is called:

A) The Sarbanes-Oxley Act

B) The Community Reinvestment Act

C) The Equal Credit Opportunity Act

D) The Truth in Lending Act

E) None of the above

Answer: C





  1. Dan Cross is a junior loan officer with First State Bank of Durant. He has been busy visiting local businesses to see of any of them need credit. Which step in the lending process is Dan performing?

A) Finding prospective customers

B) Evaluating a customer’s character and sincerity

C) Making a site visit and evaluating a customer’s credit history

D) Evaluating a prospective customer’s financial condition

E) Assessing possible collateral and signing the loan agreement

Answer: A




  1. Shelby Mann is a loan officer with the First National Bank. She interviews a potential loan customer to find out exactly why the person needs the loan and whether they would be serious about repaying the loan. Which step in the lending process is Shelby performing?

A) Finding prospective customers

B) Evaluating a customer’s character and sincerity

C) Making a site visit and evaluating a customer’s credit history

D) Evaluating a prospective customer’s financial condition

E) Assessing possible collateral and signing the loan agreement

Answer: B





  1. Jessica Simpson, a loan officer with First National Bank, visits the Tate Manufacturing Company and talks to other lenders to see their experience with Tate Manufacturing. What step in the lending process is Jessica performing?

A) Finding prospective customers

B) Evaluating a customer’s character and sincerity

C) Making a site visit and evaluating a customer’s credit history

D) Evaluating a prospective customer’s financial condition

E) Assessing possible collateral and signing the loan agreement

Answer: C





  1. Terry May, a loan officer with First National Bank, calculates liquidity and debt ratios for the Lava Lamp Company and also examines their cash flow statement. What step in the lending process is Terry performing?

A) Finding prospective customers

B) Evaluating a customer’s character and sincerity

C) Making a site visit and evaluating a customer’s credit history

D) Evaluating a prospective customer’s financial condition

E) Assessing possible collateral and signing the loan agreement

Answer: D





  1. Jerry LeGere, a loan officer with First National Bank, checks to see if the house pledged to back up a home mortgage has a clear title and proper insurance. What step in the lending process is Jerry performing?

A) Finding prospective customers

B) Evaluating a customer’s character and sincerity

C) Making a site visit and evaluating a customer’s credit history

D) Evaluating a prospective customer’s financial condition

E) Assessing possible collateral and signing the loan agreement

Answer: E




  1. The Tate Manufacturing Company has $150 million in sales revenue with $90 million in cost of goods sold. It has selling and administrative expenses of $10, pays annual taxes in the amount of $10 and has depreciation and other non cash expenses of $30 million. What are this firm’s annual projected cash flows?

A) $150

B) $60


C) $70

D) $40


E) None of the above

Answer: C





Rose/Hudgins, Bank Management and Financial Services, 8/e


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