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Chapter 20: Managing Credit Risk on the Balance Sheet
True/False
1. Provision for loan losses, net charge offs and the percentage of nonperforming loans all
increased dramatically in 2007.
Answer: r!e
"evel: Easy
2. #ross de$t service !s!ally m!st $e greater than %0& $efore a residential mortgage will $e
approved.
Answer: 'alse
"evel: (edi!m
%. A well managed $an) tries to )eep the ratio of nonperforming loans to total loans at a$o!t
*&+10&.
Answer: 'alse
"evel: Easy
4. ,ndivid!als with higher levels of income m!st have higher #-. and -. ratios to /!alify for
a loan.
Answer: 'alse
"evel: (edi!m
0. 1ollateral on a mortgage is normally only considered if the applicant has eno!gh income to
service the loan.
Answer: r!e
"evel: Easy
2. he five 1s of credit are financial capacity, collateral, conditions, connections with the $an)
and capital.
Answer: 'alse
"evel: (edi!m
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7. 1redit analysis of a mid3mar)et corporate $orrower differs from the analysis of a small
$!siness in that the analysis of the mid3mar)et $orrower is more foc!sed on the $!siness itself
and less on the $!siness owners.
Answer: r!e
"evel: (edi!m
*. As long as overall cash flow growth is positive, a $an) loan officer wo!ld not $e concerned it
cash flow from operations was pro4ected to $e negative over the term of the loan.
Answer: 'alse
"evel: (edi!m
5. he pro$a$ility distri$!tion of the dollar ret!rns on a portfolio or ris)y loans is normally
distri$!ted.
Answer: 'alse
"evel: (edi!m
10. A rising sales to wor)ing capital ratio may indicate a potential $orrower is !sing its net
c!rrent assets more efficiently.
Answer: r!e
"evel: Easy
11. he more varia$le are a $orrower6s cash flows, the lower the fi7ed charge coverage ratio
sho!ld $e to limit ris).
Answer: 'alse
"evel: Easy
12. ,ss!ance of short term de$t wo!ld res!lt in an increase in cash flow from operations on the
statement of cash flows.
Answer: 'alse
"evel: Easy
1%. ,f yo! were a loan officer eval!ating a small $!siness credit application for a loan sec!red $y
wor)ing capital yo! wo!ld generally want to see a higher 8rather than lower9 n!m$er of days in
1h 20 + 2
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inventory and n!m$er of day:s sales in receiva$les.
Answer: 'alse
"evel: (edi!m
14. ,f yo! are a lender eval!ating a loan application and yo! calc!late the following ratio: 8E;,
< "ease payments9 = >,nterest < "ease payments < 8.in)ing '!nd= 81+99? then yo! are
calc!lating a de$t service ratio and it sho!ld $e less than one in order to approve the loan.
Answer: 'alse
"evel: (edi!m
10. A firm:s cash acco!nt grew $y @%00 over the year when the firm had cash flow from
financing of +@100 and cash flow from investing of @100. he firm:s operating cash flow m!st
have $een <@200.
Answer: 'alse
"evel: Easy
12. Asset management ratios are !sed in credit analysis to help !nderstand the $orrower:s a$ility
to generate sales from the amo!nt invested in some asset category.
Answer: r!e
"evel: (edi!m
Multiple Choice
17. Aon+performing loans are loans that are past d!e BBBBBBBBBBB that are not accr!ing interest.
A9 %0 days
;9 20 days
19 50 days
-9 120 days
E9 1*0 days
Answer: 1
"evel: -iffic!lt
1*. BBBBBBBBBBBBBBBBBBBBB is the process of ta)ing possession of the mortgaged property to
satisfy the de$t in the event of fail!re to repay the mortgage and foregoing claim to any
deficiency.
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A9 Perfecting collateral
;9 'oreclos!re
19 Power of sale
-9 1onditions precedent
E9 "ien enforcement
Answer: ;
"evel: (edi!m
15. Chich one of the following is !s!ally the $etter predictor of defa!ltD
A9 .tandard and Poor:s credit rating
;9 (oody:s credit rating
19 Altman E+score
-9 F(G:s E-'
E9 All of the a$ove are e/!ally effective at predicting defa!lt
Answer: -
"evel: (edi!m
20. he $ase loan rate acco!nts for
,. he firm:s cost of f!nds
,,. he firm:s re/!ired ret!rn on e/!ity
,,,. he credit ris) of the loan
A9 , only
;9 , and ,, only
19 ,, and ,,, only
-9 , and ,,, only
E9 ,, ,, and ,,,
Answer: ;
"evel: (edi!m
21. Chich one of the following 0 16s of credit is AH correctly definedD
A9 1apacity 3 Chether the $orrower has eno!gh other credit availa$le to pay off the loan in the
event of cash flow pro$lems.
;9 1apital 3 he $orrower6s e/!ity.
19 1haracter 3 A meas!re of the $orrower6s intention=willingness to repay the loan.
-9 1onditions 3 Assessing how economic conditions co!ld affect the $orrower6s a$ility to repay
the loan.
E9 1ollateral 3 An asset of the $orrower which the lender may seiIe in the event of defa!lt on
the loan.
Answer: A
1h 20 + 4
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"evel: (edi!m
22. A corporate c!stomer o$tains a @2 million line of credit from a $an). he c!stomer agrees to
pay a 0.70& interest rate and agrees to ma)e compensating $alances of 4& of the total credit line
and 2& of the amo!nt act!ally $orrowed. hese will $e held in non+interest $earing transactions
deposits at the $an) for one year. he $an) charges a 1& loan origination fee on the amo!nt
$orrowed and a 0.%0& commitment fee on the !n!sed line of credit. he e7pected draw down
8loan amo!nt9 is 70& of the line for one year. Jeserve re/!irements are 10&. Chat is the
e7pected rate of ret!rn to the $an) 8to the nearest $asis point9D
A9 0.70&
;9 2.22&
19 2.7*&
-9 7.%%&
E9 7.*1&
Answer: -
Jesponse: Ksing methodology from the ,nstr!ctor:s (an!al: "oan amo!nt L 2( 7 .70 L 1.0(M
Kn!sed portion L 0.0(M ,ncome on the loan L >1.0( 7 80.0070 < 0.019 < 80.0(N0.00%09? L
102,700M Aet f!nds invested L >1.0( 3 80.50N 880.04N2(9 < 80.02N0.0(99? L @1.401(M ret!rn on
$an) loan L 102,700 = 1.401( L 7.%%&
"evel: -iffic!lt
2%. A corporate c!stomer o$tains a @1.0 million loan from a $an). he c!stomer agrees to pay a
2.20& interest rate and agrees to ma)e compensating $alances of 4& of the loan amo!nt. hese
will $e held in non+interest $earing transactions deposits at the $an) for one year. he $an)
charges a 1& loan origination fee on the amo!nt $orrowed. Jeserve re/!irements are 10&.
Chat is the e7pected rate of ret!rn to the $an) 8)9 8to the nearest $asis point9D
A9 2.50&
;9 7.02&
19 7.55&
-9 *.01&
E9 *.40&
Answer: ;
Jesponse: 81& < 2.20&9 = 81+84&81+10&99 L 7.02&
"evel: -iffic!lt
24. (ost loan policies specify a ma7im!m loan to val!e 8"G9 ratio on real estate loans. he
"G is a ratio of
A9 ;oo) = mar)et val!e of the loan
;9 "oan amo!nt = $orrower6s personal e/!ity
19 Kn!sed credit line = total line of credit
-9 "oan amo!nt = collateral val!e
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E9 "oan amo!nt = ma7im!m amo!nt of cons!mer de$t
Answer: -
"evel: (edi!m
Jefer to the information $elow for /!estions 20 O 22:
'ig!re 20+1
Mortgage
Applicant
Annual Gross
Incoe
!ro"ected Monthl#
Mortgage !a#ent
Annual
!ropert# Ta$es
%ther Monthl#
&e't !a#ents
Poe @100,000 @2,100 @%,000 @200
;ill @40,000 @1,000 @1,400 @100
#-. c!toff: %0&
-. c!toff: %0&
20. Ksing only the #-. criteria, which one of the following statements is tr!eD
A9 Poe gets the loan $!t not ;ill
;9 ;ill gets the loan $!t not Poe
19 ;oth get the loan
-9 Aeither get the loan
Answer: 1
Jefer to: 20+1
Jesponse: Poe: #-. L 882100 7 129 < %0009 = 100,000 L 2*.20&M ;ill: #-. L 881000 7 129 <
14009 = 40,000 L 25.7*&M $oth are !nder the ma7 of %0&
"evel: (edi!m
22. Ksing only the -. criteria, which one of the following statements is tr!eD
A9 Poe gets the loan $!t not ;ill
;9 ;ill gets the loan $!t not Poe
19 ;oth get the loan
-9 Aeither get the loan
Answer: ;
Jefer to: 20+1
Jesponse: Poe: -. L 882700 7 129 < %0009 = 100,000 L %0.40&M ;ill: #-. L 881100 7 129 <
14009 = 40,000 L %%.7*&M Poe is over the ma7im!m of %0&, ;ill is !nder
"evel: (edi!m
27. ,ndivid!al credit scoring models typically incl!de all of the following information e7cept:
A9 ,ncome
;9 "ength of time in residence
1h 20 + 2
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19 1redit history
-9 Age
E9 Ethnic $ac)gro!nd
Answer: E
"evel: (edi!m
2*. A corporate loan applicant has cash of @40, receiva$les of @00 and inventory of @20. he
applicant also has c!rrent de$ts of @20. ,f the $an):s policy re/!ires a c!rrent ratio of 1.70 or
$etter and an acid test ratio of 1.20 or $etter wo!ld the applicant receive the loanD
A9 Qes $eca!se the applicant:s c!rrent ratio and acid test ratios are accepta$le.
;9 Ao $eca!se the applicant:s c!rrent ratio and acid test ratios are $oth !naccepta$le.
19 Ao $eca!se altho!gh the applicant:s c!rrent ratio is accepta$leM its acid test ratio is not.
-9 Ao $eca!se altho!gh the applicant:s acid test ratio is accepta$leM its c!rrent ratio is not.
Answer: -
"evel: (edi!m
Jesponse: 1!rrent ratio L 840<00<209=20 L 1.25, Aot accepta$leM Acid est 840<009=20 L 1.%*,
Accepta$le
Jefer to the information $elow for /!estions 25+%0:
'ig!re 20+2
;A"AA1E .REE ;,# GA""EQ EAEJPJ,.E.
Assets Liabilities and Equity Income Statement
1ash @ 101!rrent "ia$ilities @120 1ash .ales @270
Acco!nts receiva$le *0"ong erm -e$t 2%0 1redit sales 000
,nventory 1101ommon .toc) 70 Hperating E7penses 020
'i7ed Assets 400Jetained Earnings 140 -epreciation 100
otal @200otal @200 ,nterest 00
a7es %0
Aet ,ncome D
,nterest is ;ig Galley:s only fi7ed cash charge
;ig Galley:s mar)et val!e of e/!ity to $oo) val!e of de$t ratio L 1.0
Peer Average Jatios
1!rrent Jatio 1.%0
S!ic) Jatio 0.0
-ays .ales in Jeceiva$les 00
.ales to Cor)ing 1apital 14
.ales to 'i7ed Assets 1.*
imes ,nterest Earned 4
-e$t to Asset Jatio 00&
1h 20 + 7
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Jet!rn on e/!ity 10&
25. ;ig Galley:s c!rrent ratio indicates that ;ig Galley is BBBBBB li/!id than the typical firm in
the ind!stry and ;ig Galley:s /!ic) ratio indicates that ;ig Galley is BBBBBBB li/!id than the
typical firm.
A9 more M more
;9 more M less
19 less M less
-9 less M more
E9 similar M similar
Answer: -
Jefer to: 20+2
Jesponse: 1!rrent L 810<*0<1109 = 120 L 1.2*, Peer L 1.%0M S!ic) L 810<*09 = 120 L 0.02, Peer
L 0.0
"evel: (edi!m
%0. ;ig Galley:s ret!rn on e/!ity indicates that the firm generates a BBBBB ret!rn to their
shareholders than their peers.
A9 %.02& higher
;9 10.20& higher
19 0.70& lower
-9 1.00& lower
E9 2.04& higher
Answer: -
Jefer to: 20+2
Jesponse: A,=E/!ity L 8270<000+020+100+00+%09 = 870<1409 L 1%.50&M ind!stry L 10&
"evel: (edi!m
%1. ;ig Galley has a times interest earned ratio that is BBBBBBBBB, which indicates that ;ig
Galley has BBBBBBBBB long term insolvency ris) than the typical firm in the ind!stry.
A9 4M same
;9 %.51M less
19 %.51M more
-9 4.0*M more
E9 4.0*M less
Answer: 1
Jefer to: 20+2
Jesponse: >8270 < 000 3 0209 = 009? L %.51M more
"evel: -iffic!lt
1h 20 + *
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%2. Altman6s E+score model is E L 1.2T
1
< 1.4T
2
< %.%T
%
< 0.2T
4
< 1.0T
0
T
1
L Cor)ing 1apital=otal Assets
T
2
L Jetained Earnings=otal Assets
T
%
L E;,=otal Assets
T
4
L (ar)et Gal!e E/!ity=;oo) Gal!e "ong erm -e$t
T
0
L .ales=otal Assets
Ksing the Altman6s E model, ;ig Galley6s E+score is
A9 %.22
;9 2.**
19 2.20
-9 2.11
E9 1.*0
Answer: A
Jefer to: 20+2
Jesponse: C1=A L 7.44&M JE=AL2%.14&M E;,=AL15.01&M (GE=;G"-L1.00M
.=AL1.2*M hese n!m$ers give a E score of %.22, which indicates low defa!lt ris).
"evel: -iffic!lt
%%. ;ig Galley:s fi7ed asset efficiency is BBBBBBBBBBB the typical firm in the ind!stry.
A9 the same as
;9 lower than
19 higher than
Answer: 1
Jefer to: 'ig!re 20+2
Jesponse: .='A L 8270<0009 = 400 L 1.5%70M Peer .='A L 1.*
"evel: (edi!m
%4. ;ig Galley is collecting their receiva$les a$o!t BBBBBBBBBBBBBBBBBBthan the typical firm.
A9 22& more /!ic)ly
;9 12& more /!ic)ly
19 17& more slowly
-9 12& more slowly
Answer: 1
Jefer to: 20+2
Jesponse: ;G:s -ays sales in receiva$les L 8*0 N %209 = 000 L 0*.4 daysM 0*.4=00 +1 L 12.*&
"evel: (edi!m
%0. ;ig Galley:s !se of de$t to finance assets indicates that ;ig Galley has BBBBBBBBBBBB the
typical firm in the ind!stry.
A9 more long term solvency ris) than
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;9 the same long term solvency ris) as
19 less interest e7pense than
-9 less long term solvency ris) as
E9 a lower mar)et val!e of e/!ity to $oo) val!e of e/!ity ratio than
Answer: A
Jefer to: 20+2
Jesponse: ;G -e$t=A L 8120<2%09=200 L 24.4&M Peer -e$t=A L 00&
"evel: -iffic!lt
%2. (id+mar)et commercial lending may $e typically defined as $orrowers
,. Cith sales reven!e $etween @0 and @100 million.
,,. Cith a recogniIa$le corporate str!ct!re.
,,,. Cith ready access to deep and li/!id capital mar)ets.
A9 , only
;9 ,, only
19 ,,, only
-9 , and ,, only
E9 ,, ,, and ,,,
Answer: -
"evel: (edi!m
%7. ,n analyIing credit ris) for a loan to a ma4or diversified corporation the $an) typically has
which of the following advantagesD
,. (ar)et $ased models to analyIe credit ris)
,,. #reater negotiating power d!e to the siIe of the loan re/!ired.
,,,. Jatings agency meas!res of defa!lt ris)
A9 , only
;9 , and ,, only
19 ,, and ,,, only
-9 , and ,,, only
E9 ,, ,, and ,,,
Answer: -
"evel: (edi!m
%*. A firm with a low E+score has high
A9 ,nsolvency ris)
;9 ,nterest rate ris)
19 "i/!idity ris)
-9 ,nternational ris)
E9 Aone of the a$ove
1h 20 + 10
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Answer: A
"evel: Easy
%5. ;!siness credit scoring models s!ffer from several wea)nesses. hese incl!de which of the
followingD
,. 1redit score models are not a statistically so!nd tool to !se in ma)ing a lending decision
,,. he appropriate weights on a credit score model are li)ely to change !npredicta$ly over time.
,,,. hese model ignore non+/!antifia$le $ehavioral factors s!ch as a relationship with the $an)
and rep!tation.
,G. 1redit scoring models discriminate against minorities.
A9 , and ,, only
;9 ,, and ,,, only
19 ,,, ,,, and ,G only
-9 ,, ,, and ,,, only
E9 ,, ,,, ,,, and ,G
Answer: ;
"evel: (edi!m
40. he conditions specified in a credit agreement that m!st $e f!lfilled $efore a drawdown is
allowed are called
A9 collateral perfection
;9 power of sale conditions
19 conditions precedent
-9 foreclos!re agreements
E9 a!dit review terms
Answer: 1
"evel: Easy
41. he E-' model !ses the $orrower6s c!rrent mar)et val!e of e/!ity and assets and the option
pricing model to
A9 -etermine if the e/!ity is mispriced
;9 1alc!late the mar)et val!e of the lender6s investment
19 Assess the implied ris)iness of the firm6s investments
-9 Estimate the li)elihood that the E+score model is correct
Answer: 1
"evel: (edi!m
42. A $an) charges a commercial $orrower a 2.00& interest rate on a one year loan. he $an)
1h 20 + 11
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also charges a 0.0& origination fee and re/!ires compensating $alances of 7& in the form of
demand deposits. Jeserve re/!irements are 10&. Chat is the promised gross rate of ret!rn on
the loanD
A9 *.40&
;9 7.*5&
19 5.10&
-9 7.02&
E9 2.50&
Answer: -
Jesponse: 80.000 < 0.02009 = >1 380.07 N 813 0.1099? L 7.02&
"evel: (edi!m
4%. ,f yo! were a loan officer eval!ating a small $!siness credit application for a loan and yo!
wanted to ens!re that the applicant had more than s!fficient cash flow to pay off its e7isting de$t
the applicant:s cash flow to de$t ratio wo!ld have to $e greater than
A9 Hne
;9 Eero
19 he ,E ratio
-9 he interest rate on the de$t
E9 Peer average ratio
Answer: -
"evel: -iffic!lt
44. ,n concept the JAJH1 meas!re indicates a loan is accepta$le if the JAJH1 is greater than
the
A9 ;orrower:s JHE
;9 "ender:s JHA
19 ;orrower:s JHA
-9 "ender:s JHE
E9 A1H rate
Answer: -
"evel: Easy
40. As a $!siness lender, yo! wo!ld prefer that the $orrower have sta$le or growing cash flows
res!lting from which part of the .tatement of 1ash 'lowsD
A9 'inancing cash flows
;9 1ash flows from investment
19 Hperating cash flows
-9 -ividends
E9 1ommon .toc)
1h 20 + 12
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Answer: 1
"evel: Easy
42. A $an) is !sing the JAJH1 to eval!ate large $!siness loans. he $enchmar) rate of ret!rn
is 7.00&. he one year loan interest rate is *.00& and the $an) m!st pay 7.40& to raise the
f!nds. he cost to service the loan is 0.%&. ,f the loan defa!lts, 52& of the money lent will $e
lost. ;ased on historical defa!lt rates, the e7treme worst case loss scenario is a$o!t 0&. .ho!ld
the $an) ma)e the loanD Chy or why not.
A9 Qes $eca!se the JAJH1 is 7.11&
;9 Ao $eca!se the JAJH1 is 7.11&
19 Qes $eca!se the JAJH1 is 2.02&
-9 Ao $eca!se the JAJH1 is 2.02&
E9 Ao $eca!se the JAJH1 is more than 7.00&
Answer:
Jesponse: 80.0*0 3 0.074 3 0.00%9 = 80.00N 0.529 L 2.02&, $!t this is $elow the $enchmar) of
7.00&
"evel: -iffic!lt
Short Ans(er
47. ;efore allowing the lender to act!ally ac/!ire the f!nds for a mid+mar)et collateraliIed loan
what m!st the lender ens!reD Chat type of monitoring occ!rs $y the lender after the loan is
grantedD
Answer: he lender m!st perfect the sec!rity interest in the collateral. his process incl!des
confirming that the collateral does not have a pree7isting lien that wo!ld prevent foreclos!re and
sale, ens!ring that $ac) ta7es are not owed, and in certain cases an independent assessment of the
collateral val!e may $e o$tained. 'ollowing the draw down the lender m!st monitor the
condition of the collateral periodically and reassess the $orrower:s a$ility to contin!e to service
the loan. his review normally ta)es place ann!ally.
"evel: (edi!m
4*. E7plain how the F(G model predicts $an)r!ptcy pro$a$ilityD
Answer: he F(G model calc!lates the implied volatility of a firm:s e/!ity !sing the option
pricing model. F(G also e7amines act!al defa!lt fre/!encies for firms with similar e/!ity
positions. hese two items are then !sed to estimate the implied defa!lt pro$a$ility.
"evel: -iffic!lt
1h 20 + 1%
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45. E7plain the p!rpose=$enefits in adding a credit scoring model to eval!ate a loan application.
Answer: 1redit score models allow the loan officer to /!ic)ly ma)e a decision a$o!t a loan. he
idea $ehind a credit scoring model is to identify how characteristics of past $orrowers that repaid
their loan on time differ from $orrowers that defa!lted. he differences are then weighted with a
point system and new loan applicants are then scored to see if they fall into the so!nd or defa!lt
category.
"evel: Easy
00. 'or most $!siness loans growing earnings are not a s!fficient reason to grant a loan. ChyD
Answer: 1ollateral is still important $eca!se economic conditions can change over the life of the
loan and the $an) wo!ld li)e to $e a$le to limits its losses in the event the $orrower6s earnings
are not s!fficient to repay the loan. he lender m!st also eval!ate how sensitive the $orrower6s
earnings are to economic conditions and how m!ch the economy might change over the period
of the loan. 'inally, earnings are not cash, cash is re/!ired to repay the loan and the lender will
$e more concerned a$o!t so!rces and !ses of cash than a$o!t earnings.
"evel: (edi!m
01. A @40,000 one year loan with a 1& origination fee and a 7.00& interest rate is f!nded with
money on which the $an) owes %&. Chat is the e7pected preta7 dollar spread on the loanD ,f
the $an) needs to net at least %.0& on the f!nds lent to ma)e its JHE, how many dollars can the
$an) spend on credit investigation, loan servicing, etc.D Co!ld the $an) $e a$le to spend more if
the loan amo!nt was greaterD Chat does this e7ample s!ggest a$o!t credit analysisD
Answer: #ross Jeven!e L 87.00& + %.00& < 1.00&9 N @40,000 L @2,200
(inim!m Jeven!e L 7.00& + %.00& < 1.00& + %.00& L 2.00& of @40,000 L @*00
he $an) wo!ld $e a$le to spend more money for a larger loan amo!nt. his indicates the need
for lender to employ credit scoring and other /!ic), low cost method of eval!ating small loan
amo!nts to maintain profita$ility on these transactions.
"evel: (edi!m
02. -escri$e the credit analysis process for a mid+mar)et corporate loan applicant.
Answer: he acco!nt officer gathers information a$o!t the loan applicant6s $!siness. his may
incl!de meeting the client6s e7isting c!stomers, chec)ing referrals and cold calling new $!siness
prospects. he acco!nt officer analyIes the ris) of the applicant $y applying the 0 1s of credit.
,f the acco!nt officer decides to p!rs!e the loan application, the loan is s!$mitted for review and
approval $y senior lending officials and=or a loan review committee.
"evel: (edi!m
0%. Chat are the 0 1s of creditD ;riefly descri$e each.
1h 20 + 14
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Answer: 1haracter: 1haracter of applicant, applicants willingness to wor) hard to repay the loan.
1apacity: ;orrowers a$ility to generate eno!gh cash to repay the loan.
1ondition: Row changing economic and other conditions will affect the $orrower6s
a$ility to repay.
1apital: Row m!ch capital 8protection from insolvency9 the $orrowers has.
1ollateral: he val!e of assets pledged against the loan.
"evel: Easy
04. A corporate loan applicant has had a growing cash acco!nt for the last three years $!t cash
flow from operations has $een negative in every year. Co!ld this concern yo! if yo! were the
loan officer charged with approving the loanD ,f so, whyD ,f not, why notD
Answer: his wo!ld $e a concern $eca!se it indicates cash growth is $eing generated $y either
$orrowing, new e/!ity iss!ed or $y selling assets. Aone of these are s!staina$le so!rces of
financing. (oreover, the applicant is not generating cash flow from its operations. his may
perhaps $e accepta$le if the firm is in a growth period and has good collateral, $!t the loan
officer wo!ld normally desire to have positive cash from operations.
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00. Chy won6t a loan officer !s!ally approve a loan solely on the $asis of collateralD
Answer: here are two reasons why a loan officer will not typically grant a loan if the $orrower
has ins!fficient cash flow $!t good collateral. 'irst, the lender6s rate of ret!rn is !s!ally red!ced
if the lender has to seiIe collateral and inc!r storage and sale costs, $eca!se seiIing and
disposing of collateral is very costly. ;orrowers also may not maintain collateral in the $est
condition if they $elieve it will $e seiIed and the $orrower6s f!t!re $!siness will also pro$a$ly $e
lost for good. .econd it is !nethical to grant a loan that the loan officer )nows or strongly
$elieves cannot $e repaid. Hld western G shows not withstanding, ma)ing a loan to seiIe the
collateral at a good price is $ad $!siness.
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02. E7plain what each ratio in the Altman credit model meas!res and e7plain why higher val!es
of each of the varia$les predicts lower defa!lt pro$a$ility.
Answer: he varia$les and their e7planations are:
T1 L Cor)ing capital = otal assets he higher this ratio the more li/!id assets 8&9 the firm has.
#reater li/!idity implies a stronger a$ility to pay off de$ts
in the short r!n.
T2 L Jetained earnings = otal assets he higher retained earnings are to total assets the greater
the firm:s a$ility to generate and )eep profits. his sho!ld
indicate a greater a$ility to pay off de$t.
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T% L E;, = otal assets A higher val!e for this ratio indicates a greater a$ility to
generate profits off the given assets and sho!ld indicate a
stronger a$ility to pay off de$t.
T4 L (ar)et val!e of e/!ity = ;oo) val!e of long term de$t
Chen this ratio is higher it signals that the mar)et $elieves
the firm:s a$ility to generate cash thro!gh time is strong
relative to the principal owed on the de$t, th!s indicating
the e/!ity investors $elieves the firm:s prospects are good.
T0 L .ales = otal assets his ratio meas!res the firm:s a$ility to t!rn dollars
invested in assets into sales reven!e. he higher the ratio
the greater the more efficiently managers are !sing assets
to generate sales. .ales are a cornerstone of profita$ility
and the a$ility to pay off de$ts.
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07. A $an) has a $ase loan rate of 4.70& and for the loan !nder consideration wo!ld apply a 2&
ris) premi!m. he $an) also re/!ires compensating $alances 8non+interest $earing9 e/!al to 0&
of the loan amo!nt. he $an):s reserve re/!irements are 10&. he $an) charges 1& of the loan
amo!nt as an origination fee. he $orrower is as)ing for a @000,000 loan. 1alc!late the JHA on
the loan.
Answer: "oan JHA L 80.01 <0.0470<0.029 = >1 3 80.00N813 0.109? L *.110&
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0*. A $an) can charge a corporate $orrower 2.20& on a loan. he $orrower is as)ing for a
@200,000 loan. he e7treme loss rate on this loan type is 4.0& and when defa!lt occ!rs a$o!t
10& of the loan amo!nt is recovered. he interest and noninterest cost of the loan is 0.*0&.
Chat is the JAJH1 of the loanD Knder what circ!mstances sho!ld the $an) ma)e the loanD
Answer: JAJH1 L Aet first year @ income on the loan = Gal!e of loan at ris)
Aet first year @ income on the loan L 80.0220 3 0.00*09 N @200,000 L @2,400
Gal!e of loan at ris) L -ollar val!e of loan N Kne7pected 8e7treme9 defa!lt rate N "oss given
defa!lt L @200,000 N 0.040 N 81+0.109 L @20,400
JAJH1 L @2,400 = @20,400 L 11.72&
he $an) sho!ld ma)e the loan if the $an):s JHE is less than the JAJH1 of 11.72&.
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05. Chy is $an) lending to large corporations more diffic!lt than ma)ing loans to small or mid+
siIe firmsD Chat additional factors are involvedD -o $an)s have some additional tools to help
in assessing credit ris) of large firmsD Chat are some e7amplesD
Answer: N ;an)s have red!ced $argaining power on terms with large corporations. his means
they may not $e a$le to set profita$le terms and it implies that $an)s may have to consider what
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wo!ld happen to other aspects of the $!siness relationship s!ch as cons!lting if a loan is ref!sed.
hese other relationships represent a conflict of interest with the lending f!nction.
N "arge corporate $orrowers tend to $e involved in many different lines of $!siness, ma)ing
ind!stry comparisons and ris) assessment diffic!lt.
N ,f the $orrower is a holding company that has no assets other than the separate firms, the
$an):s loan to the holding company will $e s!$ordinated to direct claims of the s!$sidiaries.
;an)s have some additional tools to help with loans to large corporations. he Altman credit
score model, the ratings from (oody:s and .tandard and Poor:s and the F(G model are
e7amples. hese tools can help the $an) assess the ris) of loan defa!lt.
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