As default or delayed repayment of a loan causes loss to the bank, the bank can not allow any loans to be defaulted either by its own erroneous decisions or by any intentional or unintentional acts on the borrower’s part. That’s why Ronald I Robinson says, “A bank never makes a bad loan, that loans get back only after they are made.. ..banks can not make loans and then forget them.”
The statement of Robinson is important. It can be divided into 2 parts –
- Bank cannot approve the loan, which has the chance to be a bad loan. If a loan became bad even though taking necessary care and precaution, it would be called bad debt.
- The bank never forgets its loans. That means the bank keeps regular communication with the borrower until the repayment is made and motivates them to return the Ioan as per the contract.
According to the writer, supervision means “the process through which lending institutions disburse the loan to the right people, ensure proper use of the credit, and more importantly make the borrower capable of repaying the loans by improving his financial condition is called supervision.
The loan supervision normally starts after the disbursement of a loan. But, before approving the loan, the supervisor should analyze the borrower’s financial status and other related information through formal or informal meetings, interviews, field investigations, etc.
From the above discussion, we can say that loan supervision should be done in three ways;
- Observe and supervise the loan applicant before approving the loan.
- After approving and disbursing the loan, supervise and monitor the cash inflow and outflow until the full repayment of the loan.
- Banks should try to retain the most creditworthy borrowers based on their repayment history and make them repeat customers because they are proven as secure and profitable to the bank. In this case, a hank may provide profitable investment advice to the borrowers.
Let’s observe the following graph where the distribution of total supervision time of the officers is depicted:
| Phases | Percentage of time spent |
| 1st Phase – Before disbursement. | 20% |
| 2nd Phase – Disbursement to repayment. | 70% |
| 3rd Phase – After the repayment of the load. | 10% |
| Total | 100% |
Ways of Loan Supervision
‘There are many ways to supervise a loan. No single way is fully effective. Thus accurate and effective supervision requires a combination of two or more ways, depending on the situation. It will need to take different initiatives for different situations to disburse the loan successfully. The followings are the ways to supervise the loans:
- Financial Statement.
- Personal Contact.
- Periodical Reports.
- Trends of Deposit Balance.
- Collection of information from those having business transactions with borrowers.
- Collection of variation of the statement of the planned and actual fund.
1. Personal contact
Loan supervisors can attend several meetings and seminars about loan supervision. It is possible to get information about the financial position through the owners and their employees. Getting information from the third parties involved with the borrower’s business is also possible.
2. Periodical Reports
Periodic financial statements can be an influential source for loan supervision. Through analysis and discussion, it is possible to observe if there is any chance to default. If any, then it can be informed to the higher authority immediately. By analyzing and supervising the statements, supervisors may take proper actions. Any errors or mistakes are informed to the higher authority if necessary.
3. Financial Statement
Through the financial statement, the profit and loss accounts of the borrowers are analyzed. Necessary actions are taken depending on the nature of variations in the profit and loss.
4. Trends in Deposit Balance
Some banks require a minimum amount of deposit when approving the loan. The loan supervisor should check the availability of minimum deposits in his and other banks. If the minimum deposit is improperly maintained, the loan supervisor immediately notices it to the higher authority and the lake.
5. Collection of Information from those having business transactions with the borrower
The bank should know the records of the nature of transactions of the other parties (suppliers, customers, etc.) with the borrower.
6. Collection of variation of the statement of Planned and Actual Funds
Supervisors are required to compare the borrower’s planned and actual fund inflow and outflow. A large extent of discrepancies in the available funds and their utilization may signal a possibility that the installment can be attained properly. If it happens, then the authority must be informed.
Essential Areas of Responsibilities and Communication Goals
Regardless of how the loan review is structured, there are several essential areas of responsibilities and communication goals starting with the examination and ending with reports to the bank’s management, including the following:
- Provide an objective grading system for loans.
- Provide current information regarding portfolio risk to management and the board on a timely basis.
- Place problem credits under additional scrutiny.
- Evaluate trends in the loan portfolio.
- Cite loan policy exceptions and non-compliance with procedures.
- Cite documentation exceptions.
- Cite violations of laws and regulations.
- Assist in the development and revision of policy and procedures.
- Act as an information source concerning emerging trends in the portfolio and the bank’s economy.
- Ensure that the portfolio conforms to the bank’s loan policy.
- Ensure that executive management and the board are informed on the bank’s asset quality and ensure dial credit standards are met in all lending activities.
- Allow lenders sufficient freedom to operate with imagination and resourcefulness without fear of censure.
Frequently Used Security in Bank
Banks normally accept the securities that are held conveniently to their business. Check out my article on types of Security for Bank Credit to understand the non-personal and personal security banks take to sanction a loan.
When a third party guarantees to pay off the loan in favor of the borrower at his default, it is known as a guarantor. Anyone cannot be a guarantor. Bank normally accepts the guarantee provided by Ilie, who is financially sound and renowned in his business.
Immovable property means fixed assets like buildings, land, machinery, etc. Fixed asset as security is safe on the one hand, but some problems might arise in their title (ownership status). Moreover, it cannot be sold at its original price. So fixed assets are less attractive to banks. Generally, long-term loans accept this type of security.
Pledge of goods is well-known security. When the borrower defaults, a bank collects money by selling the goods with prior notice. Though the goods are held in the bank’s custody, ownership remains in the borrower’s name.
But a borrower can release the goods by paying the value in proportion. Although this security is salable and liquid enough, it holds price risks.
Marketable securities mean securities traded in the capital market or the money market like shares, stock, debenture, treasury bills, government bonds, etc. Govt, autonomous institutions or private commercial and noncommercial organizations issue these.
A document of title of goods is also popular security. Among these, bills of exchange, bill of lading, railway receipt, truck receipt warehouse receipt are important.
Certificates provided by a bank for the fixed deposit are highly secured documents of a bank. Generally, the issuing bank of FDR accepts it as security, though other banks are not prohibited from doing so. The security remains valid till the duration of FDR.
Bank provides loans based on the surrender value against the insurance policy as security. Among the insurance policies, a life insurance policy is more acceptable to the bank.
Besides these, gold, valuable documents, and other expensive materials are also considered security in approving loans.
Risk-Classification Scheme
| Rating Category | Rating Scale | Collateral Support | Descriptive Indicators of Loan Quality |
|---|---|---|---|
| Highest Quality | 1 | Gov’t, securities; cash | Highest quality borrowers. 5 years of historic cash flow data. Strong balance sheet & liquidity. |
| Highest Quality | 2 | Agency & high-quality municipal securities; insured CDs | Highest quality; differs from class 1 only by the degree of financial strength. |
| Highest Quality | 3 | Uninsured CDs; high-quality stocks & bonds | Highest quality; cash flow average is slightly below classes 1 and 2. |
| Highest Quality | 4 | Gov’t, guaranteed loans; maybe unsecured | The high degree of liquidity, assets readily convertible to cash, and unused credit facilities. Strong equity capital and management. |
| Acceptable Quality | 5 | Secured by trading assets (A/R & Inv.) and/or real estate | Adequate liquidity; adequate equity capital with comfortable cash flow coverage; proactive management; cyclical industry with smaller margins |
| Acceptable Quality | 6 | Heavily dependent on collateral and/or guarantees | Partially strained liquidity; limited equity, so leverage exceeds industry norms; limited management strength; loss of business is cyclically vulnerable. |
| Acceptable Quality | 7 | Inadequate collateral | Strained liquidity, inadequate capital, and weak management. Adverse trends in industry and borrower financials. |
| Poor Quality | 8 | Inadequate collateral | Same as class 7, except financials are weaker |
| Poor Quality | 9 | Inadequate collateral | Total inadequate profile; well-defined weaknesses. |
How Borrowers and Lenders Behave over the Cycle
| Stage of Business cycle | Behavior of Borrower | Behavior of Lender |
|---|---|---|
| RecessionÂunemployment and idle capacity | – Liquidation in the case of marginal borrowers. – Faced with melting backlogs and order cancellations, repairs balance sheet liquidity; pares inventor and cuts production; receivables nin off; costÂcutting programs are undertaken: fixed costs are hard to trim quickly. – Reduces bank borrowing. – Defers nonessential capital. | – Repairs liquidity. – Excess liquidity, which erodes pricing: push for market share; irrational tendency to accept “caps” and fixed-rate deals. – Cautious on credit quality; security-conscious. |
| Recovery and expansion, commencing with pickup in consumer spending | – Continuous to repair balance sheet liquidity. – Inventor and receivable build. Increasing productivity and earnings. – Updates plant and equipment and contemplates future capital needs. More liberal on wage settlements. Overtime payments grow. – Introduces new products, and new ventures appear. – Large borrowers make extensive use of the commercial paper market | – Loan volume shows signs of a pickup in the face of excess bank liquidity. – Intense competition tends to push bankers into unsound deals. – Rates rise, and business borrowers turn to banks rather than to the bond market. |
| Boom-acceleration of inflation beyond the economy’s potential growth rate. | – Optimism Orders and prices soar above historical norms, often at unsustainable levels. – Raises wages sharply. – Reluctant to turn to long-term financing increases short and intermediate credit substantially. The supply of internally generated business funds is increasingly constrained by a low increase in physical output, which narrows profit margins. – Probes limits of physical capacity. Uses fewer productivity declines. Backlogs increase as the cycle ages. Builds inventory. – Finds cost of replacing depreciated capital equipment rising. Acquisitions and tender Offer more attractive. – Finds cost of replacing stocks of raw materials and components high. – Working capital needs rise to accommodate rising unit costs and inefficiencies. – Overall profit performance swells because of inventory profits. Profitable lines obscure the weak performance of other lines. | – Optimism mounts. – Increasing amounts loaned against increasing cash flow; overgenerosity on the part of lenders. In some instances, the liquidity supplied by the banks is all that’s keeping the borrowers afloat. – Susceptibility to euphoria and loss of perspective of what constitutes a good credit. The mania for growth, going downmarket to get it. – High dependence on cash flow for collections. – Demand for short-term funds increasingly strengthens. – Lending for capital spending grows and heats up toward the end of a maturing “up” cycle. – Acquisition loans increase. – Banks tend to become proxies for the equity and long-term debt markets. – Wise lenders exercise caution-stress avoidance of exposure to weakening borrowers. |
| Crunch-restrictive monetary policy, with restraint on the growth of bank reserves. Credit conditions and general frustration with inflation spawn proposals for credit allocation. | – Anticipatory buying of Supplies and raw materials. Increases prices wherever Possible. Wages increased in anticipation of a freeze—fears credit controls. – Liquidity declines; leverage is sometimes excessive. – Large borrowers that have relied heavily on the commercial paper market return to banks for at least part of their short-term cash needs. In anticipation of a credit squeeze, borrowers negotiate revolving and other forms of committed credit. – Marginal borrowers find it difficult to hold on. – It cuts production as backlog orders decrease. – To the extent possible, it limits borrowing as credit restraint takes hold, although inflation usually accentuates demand for credit. – Pressures on working capital affect debt servicing ability. – Tries to improve the collection of receivables as payments slow. – Takes large write-downs in recognition that assets are inflated. This could precipitate further problems, depending upon how the marketplace interprets the action. | – Cautious selective in extending new credit. – Allocates funds formally or informally; basic needs of established business customers for normal operations met to assure production and distribution of goods and services. – Discourage loans for: – Purely financial activities acquisitions or purchase of down-shares. – Speculation. – Use outside the domestic economy, funded from domestic sources. – Discretionary spending that might be deferred. Displays less flexibility on moratorium or grace periods but more flexibility on repayments. – Raises interest rates and hardens fee structure. |
Conclusion
Loan policy must be formulated with consideration of the long-term use in the loan activities. A comprehensive and written loan policy consists of detailed guidelines for the loan officers anti designated bodies.
As all instructions are mentioned in the policy, it restricts the corrupt employees from misconduct or acting against the bank’s interest.
Loan analyses must be done based on accurate and transparent information. Otherwise, wrong decisions or misinterpretations might happen.
The eight-step loan analysis has to be followed sequentially. Ignoring any single step can cause greater losses either in monetary form or in other non-monetary forms.
A loan is also a financial contract. Under this contract, necessary documents need to be kept for future contingencies, or any other obligations should arise.
On the one hand, loan supervision ensures the proper use of loaned amounts and, on the other hand, assures the repayment possibility. It also helps to build a relationship with the borrowers and makes them repeat customers.
Thus, it can be inferred here that the clear and more comprehensive loan policy, i.e., efficient loan administration, the greater it brings benefits to the loan activities, lending banks, and borrowers.