Outline the main building blocks of a sound lending or financing policy.
The idea
A lending policy is the board-approved written framework that tells every lender what business the bank wants, how much of it and on what terms. Its building blocks are the target markets and risk appetite, delegated credit approval authority graded by size and risk grade, and exposure and concentration limits. They also include underwriting standards covering analysis, documentation, collateral and covenants, risk-based pricing, monitoring and early-warning rules, classification and provisioning rules, and the treatment of exceptions and problem loans. It covers the whole life of a loan, from origination to workout. A policy is sound only if it is specific enough to test, applied independently of sales targets and reviewed as conditions change. The usual weakness is a policy that exists on paper while exceptions are approved routinely.
Formulas
Minimum risk-based loan spread
minimum spread = PD × LGD + operating cost + capital charge
- PD
- the probability of default over the year
- LGD
- loss given default, as a share of the loan
- operating cost
- annual operating cost as a share of the loan
- capital charge
- the annual cost of capital held against the loan, as a share of it
All four inputs in percent of the loan per year. Pricing at expected loss alone leaves costs and capital unpaid.
Loan-to-value ratio
LTV = loan ÷ appraised value
- loan
- the amount lent
- appraised value
- the appraised value of the property securing it
Checked against the policy's maximum alongside the debt service coverage minimum; passing one does not mean passing the other.
A practice question
Which statement best describes the purpose of a bank's lending policy?
- It fixes one interest rate for every loan so that pricing is identical across all borrowers and products.Why not: Sound policy calls for risk-based pricing; a uniform rate ignores differences in PD and LGD.
- It sets board-approved standards for what the bank lends, to whom, on what terms and under whose authority. - correct
- It sets the minimum capital ratio the bank must hold, which the regulator determines rather than the lending policy.Why not: Confuses a lending policy with capital regulation.
- It records the loans already booked and their accounting classification for external reporting.Why not: Confuses the policy with a reporting ledger; policy is forward-looking and prescriptive.
A lending policy is the written framework that governs origination, approval, monitoring, classification and workout. It is a risk-control document, not a pricing table, a capital rule or a ledger.
A harder one
A review shows that 35 percent of the loans booked last year were exceptions to the underwriting standards in the lending policy, and each exception was approved by the unit that originated the loan. Which is the most important policy weakness?
- Exceptions are not independently approved and tracked, so the policy is not effectively applied. - correct
- The policy lacks a pricing section, which explains the exceptions.Why not: Nothing in the facts points to pricing; the issue is control over deviations.
- Underwriting standards are too detailed, and should be replaced by lender discretion.Why not: Removing standards would worsen the problem; the weakness is governance of exceptions.
- The policy should limit exceptions to loans below a collateral threshold instead of controlling approvals.Why not: Collateral thresholds do not address the lack of independent approval of exceptions.
A policy is only sound if it is enforced. A high exception rate approved by the originating unit means standards are overridden without independent challenge. The fix is independent approval, reporting and escalation of exceptions.
The hardest tier
A lending policy requires a maximum loan-to-value ratio of 70 percent and a minimum debt service coverage ratio (DSCR) of 1.40 on commercial property loans. An applicant requests USD 8 million secured on a property appraised at USD 11 million. Net operating income is USD 1.10 million a year. The loan would be fully amortising over 20 years with level annual payments at 7 percent, giving a payment of about USD 0.755 million. Which standards are breached?
- Loan-to-value only: the ratio is 72.7 percent, while DSCR is about 1.46. - correct
- DSCR only: coverage is about 1.35, below 1.40.Why not: Uses an 8 percent rate for the payment instead of the stated 7 percent, producing a spurious DSCR breach.
- Both standards: LTV is above 70 percent and DSCR is below 1.40.Why not: Combines the LTV breach with the wrong-rate DSCR error; DSCR at 7 percent is about 1.46.
- Neither standard: the borrower's equity share of 27 percent is adequate.Why not: Confuses LTV with the equity share (1 - LTV); 72.7 percent LTV exceeds the 70 percent maximum.
LTV = 8 / 11 = 72.7%, above 70%. DSCR = 1.10 / 0.755 = 1.46, above 1.40. Only the LTV standard is breached.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Credit Risk Management
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- Set out what loan loss provisions and loan loss reserves are and how they work.
- Break expected loss into its components, then show how it differs from unexpected loss.
- Account for what IFRS 9 requires when expected loss is estimated.
- Outline a workout procedure for loss assets, and weigh the approach of keeping loss assets on the books against that of writing them off.
- Account for the elements that make up credit risk analysis.
- Lay out what makes up a bank's capacity to manage credit risk, and list the questions its board of directors should be asking.