Credit analysis and lending mgt
• lending is the core function of banks and other financial
institutions. It involves extending money or assets to borrowers
with the expectation of repayment with interest. There are two
main aspects to consider: the principles that guide lenders and
the basic elements of a loan.
• Principles of Lending
• These principles are essential for lenders to manage risk and
ensure the smooth operation of their business:
• Safety: This is the top priority. Lenders want to be confident that
borrowers can repay the loan in full, along with interest. They
assess this through a creditworthiness check, which considers
factors like income, credit history, and debt-to-income ratio.
• Liquidity: Banks need to maintain a balance between lending out
funds and having enough cash on hand to meet depositor
withdrawals. They may prioritize shorter-term loans to ensure
funds are readily available
Suitability of loan purpose
Loan can be given for any valid purpose.
A valid purpose is one that is legal and
conforms to the lending police of the bank.
A bank cannot lend for an activity that is not
legal. Example bank never provide loan for
narcotics trade. or for gambling and other
illegal activity
• Profitability: Lenders charge interest on loans
to earn income and cover their operating
expenses.
• The interest rate will vary depending on the
risk associated with the borrower and the loan
type.
• Diversity: Spreading loans across different
sectors and borrowers mitigates risk.
• If one industry experiences a downturn, it
won't cause a significant loss for the lender.
Lending Basics
The fundamental components of a loan include:
• Principal: The amount of money borrowed.
• Interest Rate: The cost of borrowing the money,
typically expressed as an annual percentage.
• Term: The length of time the borrower has to repay
the loan.
• Repayment Schedule: How often the borrower
makes payments and how much each payment is
for.
• Collateral: An asset that the borrower pledges as
security for the loan. If the borrower defaults, the
lender can seize the collateral to recoup their losses
• Asset classification and loan loss provisioning
are two interrelated practices crucial for
financial institutions, especially banks.
• They work together to manage credit risk and
ensure accurate financial reporting.
• Asset Classification:
• This process categorizes loans and other
financial assets based on their credit quality,
indicating the likelihood of full repayment.
• A typical classification system might include
• Pass: Loans performing according to the original
terms.
• Special Mention: Loans with minor credit
concerns that require closer monitoring.
• Substandard: Loans with significant weaknesses
or past due payments.
• Doubtful: Loans with high default risk, requiring
significant provisions.
• Loss: Loans considered uncollectible and written
off the books
• Loan Loss Provisioning:
• Based on the asset classification, lenders estimate
potential losses on loans and set aside funds
(provisions) to cover them.
• This reflects a more realistic picture of the bank's
financial health on the balance sheet.
• Provisioning Levels: The amount of provision typically
increases as the loan classification worsens.
• For example, a higher provision may be required for a
"doubtful" loan compared to a "special mention" loan.
• Benefits:
• Risk Management: Classifying assets and setting provisions
helps banks identify and manage potential loan losses.
• Accurate Financial Reporting: Provisions ensure the bank's
financial statements reflect a realistic assessment of loan
portfolio health.
• Regulatory Compliance: Financial regulations often mandate
asset classification and provisioning practices for banks.
• Improved Capital Adequacy: Provisions strengthen a bank's
capital reserves, which are essential for absorbing losses and
maintaining solvency
• Asset classification serves as the foundation
for loan loss provisioning.
• The classification determines the level of risk
associated with each loan, which directly
influences the amount of provision required.
• This ensures that banks are adequately
prepared for potential loan defaults and can
maintain financial stability
• In the credit analysis process, both financial
and non-financial information play a vital role
in assessing a borrower's creditworthiness and
the risk of defaulting on a loan.
• Financial Information:
• Provides a quantitative assessment of a
borrower's financial health. This includes:
• Financial Statements: Balance sheets, income
statements, and cash flow statements reveal a
borrower's assets, liabilities, profitability, and
cash flow generation.
– Financial Ratios: Ratios calculated from financial
statements (e.g., debt-to-equity ratio, current
ratio) provide insights into a borrower's ability to
manage debt, repay loans, and meet short-term
obligations.
– Credit History: Past borrowing behavior and
repayment performance on previous loans are
strong indicators of future creditworthiness.
• Non-Financial Information:
• Offers qualitative insights that complement financial data.
This includes:
– Management Experience: The skills, experience, and track record of
the borrower's management team can significantly impact the
success of a business and its ability to repay loans.
– Industry Trends: Understanding the overall health and outlook of
the borrower's industry can reveal potential risks or opportunities.
– Business Model: Evaluating the borrower's business model,
competitive advantages, and long-term growth prospects helps
assess the sustainability of their cash flow.
• Collateral: Assets pledged as security for the loan can provide
some level of protection for the lender in case of default
• Default is the failure to make required interest
or principal repayments on a debt, whether
that debt is a loan or a security
• A default occurs when a borrower stops
making the required payments on a debt.
• Defaults can occur on secured debt, such as a
mortgage loan secured by a house, or
unsecured debt, such as credit cards or a
student loan
• Likely causes of default
Lack of compliance with loan
Inadequate controls over loan
Over-concentration of bank lending
Loan growth exceeding bank's capabilities
Inadequate problem loan identification
Insufficient knowledge of customer’s finance
Lending in unfamiliar markets
• Debt restructuring is a process used by
companies, individuals, and even countries to
avoid the risk of defaulting on their existing
debts, such as by negotiating lower interest
rates.
• Debt restructuring provides a less expensive
alternative to bankruptcy when a debtor is in
financial turmoil, and it can work to the
benefit of both borrower and lender
• Debt restructuring is available to companies, individuals,
and even countries.
• The debt restructuring process can reduce the interest
rates on loans or extend the due dates for paying them
back.
• A debt restructuring might include a debt-for-equity
swap, in which creditors agree to cancel a portion or all
of the outstanding debt in exchange for equity in the
business.
• A nation seeking to restructure its debt might move the
debt from the private sector to public sector institutions
Sample questions
• 1. Which of the following is the TOP priority for a lender when considering a loan application?
– (a) High-interest rate to maximize profit
– (b) Short loan term to ensure quick repayment
– (c) Safety of repayment by the borrower
– (d) Loan diversification across different industries
• Explanation: While all the options are important for lenders, safety (ensuring the borrower can
repay) is the primary concern. They wouldn't lend money if there's a high risk of default.
2. A loan with a shorter term typically comes with a:
– (a) Higher interest rate due to increased risk
– (b) Lower interest rate as the lender benefits from faster repayment
– (c) Variable interest rate that fluctuates over time
– (d) No impact on interest rate, it depends on the borrower's credit score
• Explanation: Shorter terms mean less risk for the lender, so they often offer slightly lower interest
rates to incentivize quicker repayment
3. Banks need to balance lending and having enough cash on hand for withdrawals. This principle is
called:
– (a) Profitability
– (b) Safety
– (c) Liquidity
– (d) Diversity
• Explanation: Liquidity refers to the ability to meet immediate cash needs. Banks need to ensure
they have enough on hand while also lending out funds.
• 4. Which of the following statements about loan
diversification is MOST accurate?
– (a) All loans should be focused on a single industry for expertise.
– (b) Spreading loans across sectors reduces risk if one industry
struggles.
– (c) Loan diversification only benefits borrowers, not lenders.
– (d) Short-term loans inherently offer more diversification.
• Explanation: Diversification protects lenders. If a specific
industry experiences a downturn, it won't significantly
impact the lender if they have loans spread across different
sectors
5. A bank offers two loan options: a short-term loan with a lower interest rate and a long-term
loan with a higher interest rate. This practice reflects which principle of lending?
• (a) Safety
(b) Liquidity
(c) Profitability
(d) Diversity
• Explanation: This scenario highlights the principle of liquidity. By offering short-term loans,
the bank ensures they have access to cash more quickly to meet withdrawal demands.
6. If Mr chala approach for loan at awash bank, and awash banks asks capital contribution from
Mr chala equity before awash bank makes contribution. Based on the above scenario, what
awash bank requires from Mr chala is called?
• A. credit money
• B. Hurt money
• C. debt money
• D. debt for equity swap
7. Assume you are lending officers, whenever a borrower approach for a loan, what step you are
expects to do at first?
• obtain required financial statement
• check the loan application form
• obtain the prescribed loan application
• document/financial statements for any obvious inconsistencies
• 9. Assume a bank assesses history of the company, how was it set up and by whom,
the stakeholders, the products that the company manufactures or accesses and
reputation of the entity. Based on the above scenario, what type of credit analysis the
bank used?
• A. capacity
• B. character
• C. collateral
• D. condition
• E. all
10. What is the primary goal of problem loan management?
a. To minimize credit losses and preserve the lender's capital
b. To maximize loan volumes and profits for the lender
c. To satisfy borrower needs and expectations
d. To comply with regulatory requirements and standards
• Explanation: The primary goal of problem loan management is to minimize credit
losses and preserve the lender's capital.
11. The primary purpose of asset classification in loan portfolios is to:
• (a) Determine interest rates for loans
(b) Categorize loans based on credit quality
(c) Simplify loan repayment schedules
(d) Track loan origination dates
• Explanation: (b) Categorize loans based on credit quality - Asset classification
helps assess the risk of default for each loan
12. Which of the following statements about loan loss provisioning is NOT true?
• (a) Provisions are set aside to cover potential losses on loans. (b) Higher
provisions are typically required for riskier loans. (c) Loan loss provisions
improve a bank's profitability. (d) Provisions provide a more realistic picture of
a bank's financial health.
• Explanation: (c) Loan loss provisions improve a bank's profitability. -
Provisioning reduces reported profits, but reflects a more accurate financial
picture.
13. Which of the following benefits does NOT come from effective asset classification and loan
loss provisioning?
• (a) Improved capital adequacy for banks
(b) Reduced risk of loan defaults
(c) Increased regulatory scrutiny
(d) More accurate financial reporting
• Explanation: (b) Reduced risk of loan defaults - While these practices help manage risk,
they cannot eliminate defaults entirely
14. Which of the following statements is NOT true about using non-financial information in
credit analysis?
• (a) It can help assess the borrower's management capabilities.
• (b) It can provide insights into the overall health of the borrower's industry.
• (c) It can be used to determine the interest rate charged on a loan.
• (d) It should be given equal weight to financial information in all situations.
• Explanation: (c) It can be used to determine the interest rate charged on a loan. - While a
borrower's industry and management can influence the interest rate, financial factors like
creditworthiness and loan terms typically have a more direct impact
15.What is the primary goal of problem loan management?
a. To minimize credit losses and preserve the lender's capital
b. To maximize loan volumes and profits for the lender
c. To satisfy borrower needs and expectations
d. To comply with regulatory requirements and standards
• Explanation: The primary goal of problem loan management is to minimize credit
losses and preserve the lender's capital.
• 16. What is loan restructuring?
a. The process of modifying the terms of a loan to help a borrower in financial
difficulty
b. The process of refinancing a loan to obtain a lower interest rate
c. The process of repaying a loan in full before the due date
d. The process of extending the loan term to reduce the monthly payment amount
• Explanation: Loan restructuring is the process of modifying the terms of a loan to
help a borrower in financial difficulty, such as changing the payment schedule,
interest rate, or loan balance.
• 117. What is foreclosure?
a. The legal process of seizing collateral used to secure a loan when the borrower
defaults
b. The process of modifying the terms of a loan to help a borrower in financial difficulty
c. The process of refinancing a loan to obtain a lower interest rate
d. The process of extending the loan term to reduce the monthly payment amount
• Explanation: Foreclosure is the legal process of seizing collateral used to secure a loan
when the borrower defaults, and is typically used as a last resort
• 18. Why is asset classification important?
a. To manage credit risk and set appropriate loan loss provisions
b. To increase profits for the financial institution
c. To provide borrowers with more favorable loan terms
d. To avoid regulatory scrutiny
• Explanation: Asset classification is important to manage credit risk and set appropriate
loan loss provisions, which ensures the financial institution maintains adequate capital
to cover potential loan losses
• 19. What is the purpose of loan loss provisioning?
a. To ensure the financial institution maintains adequate capital levels to absorb
potential losses
b. To increase the profitability of the financial institution
c. To provide borrowers with more favorable loan terms
d. To avoid regulatory scrutiny
• Explanation: The purpose of loan loss provisioning is to ensure the financial
institution maintains adequate capital levels to absorb potential losses and remain
financially stable.
• 20. What is the impact of asset classification on loan loss provisioning?
a. Assets classified as higher risk require higher loan loss provisions
b. Assets classified as lower risk require higher loan loss provisions
c. Assets classified as higher risk require lower loan loss provisions
d. none
• Explanation: Assets classified as higher risk require higher loan loss provisions, as
they are more likely to result in credit losses.
• 21. What is the role of loan loss provisioning in financial statements?
a. It is recorded as an expense and reduces the financial institution's equity
b. It is recorded as an asset on the financial institution's balance sheet
c. It is recorded as interest income on the financial institution's income statement
d. It has no impact on the financial institution's financial statements
• Explanation: Loan loss provisioning is recorded as an expense on the financial
institution's income statement, which reduces the financial institution's equity.
• 22. What is the impact of asset classification on lending decisions?
a. Loans to higher risk assets may be denied or offered at higher interest rates
b. Loans to lower risk assets may be denied or offered at higher interest rates
c. Loans to higher risk assets may be approved at lower interest rates
d. Loans to lower risk assets may be approved at lower interest rates
• Explanation: Loans to higher risk assets may be denied or offered at higher
interest rates to compensate for the higher credit risk.
• 23. How does loan loss provisioning impact loan pricing?
a. Higher loan loss provisions may lead to higher loan pricing to compensate for the increased
credit risk
b. Lower loan loss provisions may lead to higher loan pricing to compensate for the decreased
credit risk
c. Loan loss provisioning has no impact on loan pricing
d. Loan pricing is determined solely by the borrower's creditworthiness and financial history
• Explanation: Higher loan loss provisions may lead to higher loan pricing to compensate for the
increased credit risk, as the financial institution seeks to cover potential losses.
• 24. What is the difference between credit risk analysis and credit risk management?
a. Credit risk analysis is the process of evaluating creditworthiness, while credit risk management
is the process of mitigating potential losses
b. Credit risk analysis is the process of tracking loan repayments over time, while credit risk
management is the process of setting interest rates
c. Credit risk analysis is the process of evaluating market conditions, while credit risk
management is the process of evaluating financial statements
d. Credit risk analysis and credit risk management are the same process
• Explanation: Credit risk analysis is the process of evaluating creditworthiness, while credit risk
management is the process of mitigating potential losses
• 25.What is the impact of borrower diversity on loan portfolio management?
a. Diverse borrower portfolios can lead to lower credit risk and higher returns
b. Diverse borrower portfolios can lead to higher credit risk and lower returns
c. Diverse borrower portfolios have no impact on loan portfolio management
d. Diverse borrower portfolios can only be achieved for large financial institutions
• Explanation: Diverse borrower portfolios can lead to lower credit risk and higher returns, as a variety of
borrowers reduce the concentration of risk in any single borrower.
• 26. What is the role of a bank in a letter of credit transaction?
a. To provide a guarantee of payment to the seller
b. To provide a loan to the buyer
c. To provide legal advice to the parties
d. To evaluate the creditworthiness of the parties
• Explanation: The role of a bank in a letter of credit transaction is to provide a guarantee of payment to the
seller, subject to certain conditions being met.
• 27. What is the primary purpose of a letter of credit?
a. To provide a guarantee of payment to a seller
b. To outline the terms and conditions of a loan
c. To establish a legal obligation to repay a loan
d. To set interest rates and repayment schedules for a loan
• Explanation: The primary purpose of a letter of credit is to provide a guarantee of payment to a seller or
supplier.
28.Which one is correct about problem loan management?
• A. The process of identifying and addressing non-performing loans
• B. The process of reviewing loan applications and approving loans
• C. The process of documenting and recording loan agreements
• D. The process of marketing loans to potential borrowers
• Explanation: Problem loan management is the process of identifying and
addressing non-performing loans, or loans that are at risk of default
29. What is the impact of borrower diversity on loan portfolio management?
• A. Diverse borrower portfolios can lead to lower credit risk and higher returns
• B. Diverse borrower portfolios can lead to higher credit risk and lower returns
• C. Diverse borrower portfolios have no impact on loan portfolio management
• D. Diverse borrower portfolios can only be achieved for large financial
institutions
• Explanation: Diverse borrower portfolios can lead to lower credit risk and
higher returns, as a variety of borrowers reduce the concentration of risk in
any single borrower
