LV Thạc sỹ_Strengthening loan management in Vietcombank

RESEARCH DISSERTATION

“STRENGTHENING LOAN
MANAGEMENT
IN VIETCOMBANK”

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ACKNOWLEDMENT
The author would like to express her sincerest gratitude to Dr. ….
Last but not least, the author remains grateful to her family members for their continued
moral support during her study of the MBA course at CFVG.

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TABLE OF CONTENT
ACKNOWLEDMENT............................................................................................................1
LIST OF ABBREVIATIONS...................................................................................................7
INTRODUCTION.....................................................................................................................8
1. Rationale of the Research...............................................................................................8
2. Problem statement..........................................................................................................9
3. Objectives of the research............................................................................................10
4. Methodology and the Research design........................................................................10
5. Scope and limitation.....................................................................................................10
CHAPTER I: THEORITICAL BACKGROUND...............................................................11
1.1. Definition...................................................................................................................11
1.2. Types of Bank Loans.................................................................................................12
1.3. Loan (debt) Classification and Provision..................................................................14
1.4. Risks Associated with Lending.................................................................................16

1.5. International Experience on Loan Management.......................................................22
1.5.1. Major Causes of Problem Loans........................................................................22
1.5.2. Detecting Problem Loans...................................................................................25
1.5.3. Resolving Problem Loans..................................................................................27
CHAPTER II: LOAN MANAGEMENT ACTIVITIES IN VIETCOMBANK...............30
2.1. Introduction of Vietcombank....................................................................................30
2.1.1. Historical development of Vietcombank............................................................30
2.1.2. Organizational Structure....................................................................................31
2.2. Lending Performance in Vietcombank during the period 2005-2008.......................33
2.3. Loan Management in Vietcombank..........................................................................39
2.3.1. Organization.......................................................................................................39
2.3.2. Function of Loan Management Department......................................................40
2.3.3. Lending Approval Procedure.............................................................................41
2.3.4. Loan Management Procedure.............................................................................44
2.4. Applying Internal Credit Rating System...................................................................44
2.5. Problem Loans Handling...........................................................................................48
2.6. Loan Management Achievements.............................................................................49

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2.6.1. Achievements.....................................................................................................49
2.6.2. SWOT analysis...................................................................................................50
2.6.2.1 Strengths.......................................................................................................50
2.6.2.2. Weaknesses..................................................................................................50
2.6.2.3. Opportunities...............................................................................................51
2.6.2.4. Threats.........................................................................................................51
CHAPTER III: RECOMMENDATIONS TO STRENGTHEN LOAN MANAGEMENT
ACTIVITIES...........................................................................................................................53
3.1. The Objectives and Tasks for Lending Activities in the Period 2009-2010..............53

3.2. Solutions to Improve Loan Management Quality of Vietcombank in the Coming
Years ..............................................................................................................................54
3.2.1. Loan Repayment................................................................................................54
3.2.2. Calculating the Return on a Loan.......................................................................54
3.2.3. Evaluating and Managing Concentrations of Risk.............................................57
3.2.4. Loan Portfolio Diversification...........................................................................60
3.2.5. Better Debt Classification and Provision...........................................................62
3.2.6. Strengthen the Capacity of Loan Management Department..............................64
3.2.7. Improve NPL Management................................................................................65
CONCLUSION........................................................................................................................66
REFERENCES........................................................................................................................67

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LIST OF TABLES AND CHARTS

Chart 2.1

Vietcombank’s Organizational Structure

Page 30

Table 2.1

Some Major Financial Highlights of Vietcombank in the
period 2005 – 2008

Page 31

Chart 2.2

Outstanding Loans and Income from Lending from 20052008

Page 32

Table 2.2

Outstanding Loans by Type of Customers

Page 34

Chart 2.3

Outstanding Loans by Industry

Page 35

Table 2.3

Bank’s Loan Classification and Loan Loss Provision under
Decision 493

Page 36

Table 2.4

Bad Debt Written off

Page 37

Table 2.5

Credit Approval Body in Vietcombank

Page 40

Table 2.6

Credit Approval Level for Branch

Page 41

Chart 2.4

ICRS Process

Page 43

Chart 2.5

Financial Marking Criteria

Page 43

Chart 2.6

Non Financial Marking Criteria

Page 44

Table 2.7

Loan Classification and Provision according to ICRS

Page 44

Chart 2.7

Report Making Procedure under ICRS

Page 46

Table 2.8

Solutions to Handle NPL in 9 months 2009

Page 47

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LIST OF ABBREVIATIONS
FI
Vietcombank
Or VCB
C&I Loans
Decision 493

Financial Institution

Bank for Foreign Trade of Vietnam
Commercial and Industrial Loans
Decision 493-2005-QD-NHNN of the State Bank
dated 22 April 2005 on debt classification

LPM

Loan portfolio management

MIS

Management information system

NPL

Nonperforming loan

ICRS

Internal Credit Rating System

ALCO

Asset/liability management committee

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INTRODUCTION
1.

Rationale of the Research

Vietnam is in the process of industrialization, modernization and aggressively
integration into the world economy. Over the past 10 years, the Country witnessed a
relatively higher level of economic growth rate to almost the rest of the world,
7.3%/year on average. To be able to achieve the goals of Vietnam economy’s entities in
the coming years, there exists the demand for a huge capital. In this context, a credit
expansion rate of about 30% (suggested by State Bank) per year can hardly meet the
need for capital of Vietnam’s businesses and individuals. But high credit expansion rate
does not mean less attention to debt quality as well as loan management. For
Vietnamese Credit Institutions, the matter of loan quality and loan management has
become more important than ever before because they are undergoing such a high
credit risks.
Moreover, the global financial depression 2008-2009 is hurting the world economy
most seriously since the World War II. The Financial sector is now facing much
changes and challenges, especially the merger and acquisition of financial institutions
in the world. The crisis in real estate leads to the bankrupt of many giant banks in the
world, such as: Lehman Brothers, Washington Mutual’s, and Fannie Mae, Freddie Mac,
Chiffon Bank, Colonial Bank… The failure of the US financial bailout has had effect
not only on American, European financial market but also in Asia and the whole world.
While Financial Institutions have faced difficulties over the recent period for a dozen of
reasons, the major cause of serious banking problems continues to be directly related to
lax credit standard for borrowers and counterparties, poor portfolio risk management…
The global financial depression and the merger and acquisition trend have put
Vietnam’s economy and financial market under pressure, which require new changes to
overcome such difficulties, for example: the modernization of bank system’s
infrastructure, credit risk management, and human resource training…
As the oldest commercial bank for external affairs in Vietnam, Vietcombank has
always been known as the most prestigious bank in trade finance, international

payments, foreign exchange, guarantee and other banking and financial services,
including credit cards: Visa, Master Card. With the motto “ALWAYS FOR
CUSTOMERS' SUCCESS", the Bank's dominant objective is to maintain the role of a
leading commercial bank in Vietnam and to be an international bank in the region in

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the next decade. For Vietcombank, lending represent the heart of the banking industry,
loans are the dominant asset which generate the largest share of operating income and
represent the Bank’s greatest risk exposure. Departments joining in the credit/lending
procedure as well as the whole bank have paid such a properly giant attention and
effort to improve the loan quality and strengthening the loan management activities of
Vietcombank.
Carrying out my consultancy project in the Loan Management Department and been
assigned to study the current situation of Vietcombank’s Loan management operations;
to find out the solutions to improve or overcome such weaknesses to be found, I chose
the task “Strengthening loan management in Vietcombank” with the aim of having an
overview of Vietcombank’s loan quality, loan management activities, hence be able to
propose essential solutions to raise loan management quality in Vietcombank.
2. Problem statement
Over the past two decades, the loan quality of many Financial Institutions’ lending and
investment decision has attracted a great deal of attention. In the 1980s, there were
tremendous problems with bank loans to less developed countries as well as with thrift
and bank residential and farm mortgage loans. In the early 1990s, attention switched to
the problems of commercial real estate loans (to which banks, thrifts and insurance
companies were all exposed) as well as junk bonds. More recently, concerns have been
raised about the rapid growth in low-quality auto loans which lead to the financial
crisis all over the world.
The exposure to credit risk continues to be the leading source of problems in banks

worldwide, especially when global crisis is booming. Loan repayment capacity of
enterprises – borrowers is weakening, bad debt ratio rising. Thus, the matter of Loan
management is more important than ever before.
Working for Vietcombank, in Loan Management Department, I have a chance to get
access and deeply understand the Loan management system, which has been paid much
attention but still be in need of innovation. That innovation may include: better IT
system, helpful credit rating system, credit risk rating model, suitable strategy, better
loan portfolio management, and better collection of related external or corporate
information…
After studying the importance of loan management and the situation of Vietcombank, I
realize the fact that VCB need lots of reform or innovation to improve the loan quality
and loan management activity to meet the international standards and keep her safe
from the global economic and financial crisis.

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3. Objectives of the research
The objectives of the Research are formulated as followed:
1. To gain a full view on credit or loan quality and loan management activities: the
features, importance, operation…
2. To analyze the specific situation and shortcomings of loan quality and loan
management activities in Vietcombank.
3. To draw out some recommendations to get a better loan quality and loan
management system in Vietcombank.
4. Methodology and the Research design
The Research will cover fact, concepts, techniques and approaches explored from loan
management and controlling activities. The Research uses general, analytical,
comparative and statistical methods with using charts, tables and factual data for
support. From the collected information and data, the writer assesses and analyses the

situation to draw conclusion and find out feasible solutions to improve Loan
management in Vietcombank.
Structure of the Research:
The Research consists of Introduction, Conclusion and three main chapters as follows:
Chapter I: Theoretical background
Chapter II: Loan management activities in Vietcombank
Chapter III: Recommendations to strengthen Loan management activities
5. Scope and limitation
Credit outstanding balance in Vietcombank includes loans, trade finance, discount and
rediscount commercial notes, payment for guarantee, overdraft and so on. Among
those, loan always takes the largest part which is managed in Loan Management
Department. In this thesis, the scope of Loan management in Vietcombank focuses on
loans for company, especially for big firms in Head office.
The Research refers to theoretical frameworks on Loan management and related issues
at commercial bank and actual loan management activities in Vietcombank. After
analysis, the Research states out problems that Loan management activity facing and
recommend on solutions to improve Loan management quality in Vietcombank.

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CHAPTER I:

THEORITICAL BACKGROUND
1.1. Definition
Loan is An arrangement in which a lender (usually the Bank) gives money or
property to a borrower, and the borrower agrees to return the property or repay the
money, usually along with interest, at some future point(s) in time. Usually, there is a
predetermined time for repaying a loan, and generally the lender has to bear the risk
that the borrower may not repay a loan (though modern capital markets have

developed many ways of managing this risk).
Getting a bank loan has become a very popular means of acquiring something, which
otherwise would not have been possible without getting a loan from a bank. An
individual can obtain a bank loan to own anything under the sun. Bank loans make it
possible for an individual to own a house, own a vehicle, and repair one's house.
Lending is the principal business activity for most commercial banks. The loan
portfolio is typically the largest asset and the predominate source of revenue. As
such, it is one of the greatest sources of risk to a bank’s safety and soundness.
Whether due to lax credit standards, poor portfolio risk management, or weakness in
the economy, loan portfolio problems have historically been the major cause of bank
losses and failures. Effective management of the loan portfolio and the credit
function is fundamental to a bank’s safety and soundness. Loan portfolio
management (LPM) is the process by which risks that are inherent in the credit
process are managed and controlled. Because review of the LPM process is so
important, it is a primary supervisory activity. Assessing LPM involves evaluating
the steps bank management takes to identify and control risk throughout the credit
process. The assessment focuses on what management does to identify issues before
they become problems.
Loan Management: Loan management’s overall objectives are to improve loan
quality, recognizing and minimizing problem loans, identifying appropriate solutions
and minimizing exposure to lender liability. Loan management activities include but
not limit to: withdrawing cash, monitoring loan performance, collecting principal and
interest, storing credit documents, updating the network system information on credit
facility, collateral assets, outstanding balance and execute internal credit rating,
supervising the inspection of loan usage’s objective, treating with loan risk

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appearance, loan classification and provision, non performing loan management,

making period and ad-hoc credit reports…
1.2. Types of Bank Loans
Although most Financial Institutions make loans, the types of loans made and the
characteristics of those loans differ considerably. This part analyzes the major types
of loans made by Commercial Banks, including: commercial and industrial loans,
real estate loans, individual (consumer) loans and other loans.
Commercial and Industrial Loans: can be made for periods as short as a few weeks
to as long as ten years or more. Traditionally, short-term commercial loans (those
with an original maturity of one year or less) are used to finance firms’ working
capital needs and other short term funding needs while long-term commercial loans
are used to finance credit needs that extend beyond one year, such as the purchase of
real assets (machinery), new venture start-up costs and permanent increases in
working capital. They can be made in quite small amount such as $10,000 to small
businesses or in package as large as $10 million or more to major corporations. Large
C&I loans are often syndicated. A syndicated loan is provided by a group of FIs as
opposed to a single lender. A syndicated loan is structured by the lead FI (or agent)
and the borrower. Once the term (rates, fees and covenants) are set, pieces of the loan
are sold to other FIs. In addition, C&I loans can be secured or unsecured. A secured
loan (or asset-backed loan) is backed by specific assets of the borrower; if the
borrower defaults, the lender has a first lien or claim on those assets. In the
terminology of finance, secured debt is senior to an unsecured loan (or junior debt)
that has only a general claim on the assets of the borrower if default occurs. Then,
there is a trade-off between the security or collateral backing of a loan and the loan
interest rate or risk premium charged by the lender on a loan.
In addition, C&I loans can be made at either fixed rates of interest or floating rate. A
fixed-rate loan has the rate of interest set at the beginning of the contract period. This
rate remains in force over the loan contract period no matter what happens to market
rates. And it is the lender who bears all the interest rate risks. This is why many loans
have floating-rate contractual terms. The loan rate can be periodically adjusted
according to a formula so that the interest rate risk is transferred in large part from

the FI to the borrower. As might be expected, longer-term loans are more likely to be
made under floating-rate contracts than are relatively short-term loans.

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Finally, loans can be made either spot or under commitment. A spot loan is made by
the FI and the borrower uses or takes down the entire loan amount immediately. With
a loan commitment, or line of credit, by contrast, the lender makes an amount of
credit available such as ten million; the borrower has the option to take down any
amount up to the $10 million at any time over the commitment period. In a fixed-rate
loan commitment, the interest rate to be paid on any takedown is established when
the loan commitment contract originates. In a floating-rate commitment, the
borrower pays the loan rate in force when the loan is actually taken down.
Real Estate Loans: are primarily mortgage loans and some revolving home equity
loans. As with C&I loans, the characteristics of residential mortgage loans differ
widely. These characteristics include the size of loan, the ratio of the loan to the
property’s price (the loan price or loan value ratio) and the maturity of the mortgage.
Other important characteristics are the mortgage interest (or commitment) rate and
fees and charges on the loan, such as commissions, discounts and points paid by the
borrower or the seller to obtain the loan. In addition, the mortgage rate differs
according to whether the mortgage has a fixed rate or a floating rate, also called an
adjustable rate. Adjustable rate mortgages have their contractual rates periodically
adjusted to some underlying index, such as the one-year T-bond rate. The proportion
of fixed-rate to adjustable rate mortgage in FI portfolios varies with the interest rate
cycle. In low interest rate periods, borrowers prefer fixed-rate to adjustable rate
mortgages. As a result, the proportion of adjustable rate mortgages to fixed-rate
mortgages can vary considerably over the rate cycle.
Residential mortgage are very long-term loans with an average maturity of about 1015 years. To the extent that house prices can fall below the amount of the loan
outstanding – that is, the loan to value ratio rise – the residential mortgage portfolio

can also be susceptible to default risk. For example, during the collapse in real estate
price in America in 2008, many houses prices actually fell below the price of early
2007. This led to a dramatic surge in the proportion of mortgages defaulted on and
eventually foreclosed many banks and FIs.
Individual (Consumer) Loans: Another major type of loan is the individual or
consumer loan, such as personal and auto loans. Commercial banks, finance
companies, retailers, savings institutions, credit unions… also provide consumer
loans. There are two major classes of consumer loans at commercial banks. The
largest class of loan is non-revolving consumer loans, which include new and used
automobile loans, mobile home loans and fixed-term consumer loans. The other

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major class of consumer loans is revolving loans, such as credit card debt. With a
revolving loan, the borrower has a credit line on which to draw as well as to repay up
to some maximum over the life of the credit contract.
Other loans: The other loans category can include a wide variety of borrowers and
types, including farmers, other banks, nonbanking financial institutions (such as call
loans to investment banks), broker margin loans (loans financing a percentage of an
individual investment portfolio), state and local governments, foreign banks…
1.3. Loan (debt) Classification and Provision
According to Decision 493, all credit institution operating in Vietnam (excluding the
Bank for Social Policies) are subjected to debt classification and loss provisioning
requirements. Decision 493, however, allows foreign bank branches licensed to
operate in Vietnam, subject to State Bank of Vietnam approval, to apply the loss
provisioning policies of their parent banks. Bank Debt is classified into five
categories under Quantitative and Qualitative method.
The Quantitative Method primarily is based on the period that payment of principle
and interest being overdue.

Category 1 (pass): debts that are not due and the borrower is able to pay the principle
and interest of debts in full and in a timely manner.
Category 2 (special-mention): debts that are overdue less than 90 days and
rescheduled debt that are not due.
Category 3 (sub-standard): debts that are overdue from 90 to 180 days and
rescheduled debt that are overdue less than 90 days.
Category 4 (doubtful): debts those are overdue from 181 to 360 days and rescheduled
debts that are overdue from 90 to 180 days. And
Category 5 (loss): debts that are overdue more than 360 days, rescheduled debts that
are overdue more than 180 days and debts that are subject to rescheduling
arrangements as directed by the Government.
However, loans may be subject to a worse rating if there are reasons to doubt the
borrower’s ability to continue to service such loans.
Qualitative Method: is based on the credit’s institution’s internal credit ranking
system and provisioning policy as approved by the State Bank of Vietnam. Debts are
also classified as pass, special-mention, sub-standard, doubtful, and loss.

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Category 1 (pass): debts that the borrower is able to pay the\
Principle and the interest in full and timely manner.
Category 2 (special-mention): debts that the borrower is able to pay the principle and
the interest in full but there exists a sign of decreasing payment ability.
Category 3 (sub-standard): debts that the borrower is not able to pay the principle
and the interest in a timely manner and some loss of principle and interest is possible.
Category 4 (doubtful): debts in relation to which the loss of principle and interest is
highly probable. And
Category 5 (loss): debts that are uncollectible.
Provisioning: Decision 493 provides two types of loss provisioning, specific

provisions and general provisions. Provisions established to absorb unidentified
losses inherent in a credit institution’s loan portfolio are referred to as general
provisions and provisions established to absorb losses indentified for specific loans
are referred to as specific provisions. Specific provision is already being
implemented by credit institutions. General provisions are introduced for the first
time in Decision 493 and are equal to .075% of the total debt classified from
category 1 to category 4.
Under either the qualitative method or quantitative method, the ratios of specific
provision for debts of categories from 1 to 5 are: 0%, 5%, 20%, 50% and 100%,
respectively. The formula for calculating specific provisions under Decision 493 is as
follows:
R = max {0, (A-C) x r}
In which, R: a specific amount for loss reserve
A: the value of the asset (i.e., the loan)
C: the value of the collateral (after being discounted by such percentage
as set forth in Decision 493 for each type of collateral)
r: ratio for loss provisioning
It should be noted that the value of the collateral set forth in the underlying security
agreement will be the basis for calculating the loan loss reserve with respect to most
types of collateral (generally except for gold and securities). In practice, credit
institution normally imposes a nominal value of the collateral on the date of the
security agreements.

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Use of Loss Reserves: Loss reserves are used when customers are bankrupt or
dissolved (for customer being organizations or dead or missing (for customers being
individuals). Loss reserves are also used when loans are classified as debts in
category 5. In such case, specific provisions and the realization proceeds of the

collateral are used first to compensate for the loss. General provisions are used as the
last resort.
1.4. Risks Associated with Lending
Risk is the potential that events, expected or unexpected, may have an adverse
impact on the bank’s earnings or capital. These risks are credit, interest rate, liquidity,
price, foreign exchange, transaction, compliance, strategic, and reputation. Banks
with international operations are also subject to country risk and transfer risk. These
risks are not mutually exclusive; any product or service may expose the bank to
multiple risks
A key challenge in managing risk understands the interrelationships of the nine risk
factors. Often, risks will be either positively or negatively correlated to one another.
Actions or events will affect correlated risks similarly. For example, reducing the
level of problem assets should reduce not only credit risk but also liquidity and
reputation risk. When two risks are negatively correlated, reducing one type of risk
may increase the other. For example, a bank may reduce overall credit risk by
expanding its holdings of family residential mortgages instead of commercial loans,
only to see its interest rate risk soar because of the interest rate sensitivity and
optionality of the mortgages. Lending can expose a bank’s earnings and capital to all
of the risks. Therefore, it is important that the examiner assigned LPM understands
all the risks embedded in the loan portfolio and their potential impact on the
institution. How each of these categories relates to a bank’s lending function is
detailed in the following sections.
Credit Risk
For most banks, loans are the largest and most obvious source of credit risk.
However, there are other pockets of credit risk both on and off the balance sheet,
such as the investment portfolio, overdrafts, and letters of credit. Many products,
activities, and services, such as derivatives, foreign exchange, and cash management
services also expose a bank to credit risk. The risk of repayment, i.e., the possibility
that an obligor will fail to perform as agreed, is either lessened or increased by a
bank’s credit risk management practices. Because a bank cannot easily overcome

borrowers with questionable capacity or character, these factors exert a strong

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influence on credit quality. Borrowers whose financial performance is poor or
marginal, or whose repayment ability is dependent upon unproven projections can
quickly become impaired by personal or external economic stress. Management of
credit risk, however, must continue after a loan has been made, for sound initial
credit decisions can be undermined by improper loan structuring or inadequate
monitoring. Traditionally, banks have focused on oversight of individual loans in
managing their overall credit risk. While this focus is important, banks should also
view credit risk management in terms of portfolio segments and the entire portfolio.
Effective management of the loan portfolio’s credit risk requires that the board and
management understand and control the bank’s risk profile and its credit culture. To
accomplish this, they must have a thorough knowledge of the portfolio’s composition
and its inherent risks. They must understand the portfolio’s product mix, industry and
geographic concentrations, average risk ratings, and other aggregate characteristics.
They must be sure that the policies, processes, and practices implemented to control
the risks of individual loans and portfolio segments are sound and that lending
personnel adhere to them.
Banks engaged in international lending face country risks that domestic lenders do
not. Country risk encompasses all of the uncertainties arising from a nation’s
economic, social, and political conditions that may affect the payment of foreigners’
debt and equity investments. Country risk includes the possibility of political and
social upheaval, nationalization and expropriation of assets, governmental
repudiation of external indebtedness, exchange controls, and currency devaluation or
depreciation. Unless a nation repudiates its external debt, these developments might
not make a loan uncollectible. However, even a delay in collection could weaken the
lending bank.

Transfer risk, which is a narrower form of country risk, is the possibility that an
obligor will not be able to pay because the currency of payment is unavailable. This
unavailability may be a matter of government policy. For example, although an
individual borrower may be very successful and have sufficient local currency cash
flow to pay its foreign (e.g., U.S. dollar) debt, the borrower’s country may not have
sufficient U.S. dollars available to permit repayment of the foreign indebtedness. The
transfer risk associated with banks’ exposures in foreign countries is evaluated by the
Interagency.

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Interest Rate Risk
The level of interest rate risk attributed to the bank’s lending activities depends on
the composition of its loan portfolio and the degree to which the terms of its loans
(e.g., maturity, rate structure, and embedded options) expose the bank’s revenue
stream to changes in rates. Pricing and portfolio maturity decisions should be made
with an eye to funding costs and maturities. When significant individual credits or
portfolio segments are especially sensitive to interest rate risk, they should be
periodically stress-tested. If the asset/liability management committee (ALCO),
which typically is responsible for managing the bank’s interest rate risk, is to manage
all of the bank’s positions, it must have sufficient reports on loan portfolio and
pipeline composition and trends. These reports might include a maturing loans
report, pipeline report, and rate and reprising report.
Banks frequently shift interest rate risk to their borrowers by structuring loans with
variable interest rates. Borrowers with marginal repayment capacity may experience
financial difficulty if the interest rates on these loans increase. As part of the risk
management process, banks should identify borrowers whose loans have heightened
sensitivity to interest rate changes and develop strategies to mitigate the risk. One
method is to require vulnerable borrowers to purchase interest rate protection or

otherwise hedge the risk.
Liquidity Risk
Because of the size of the loan portfolio, effective management of liquidity risk
requires that there be close ties to, and good information flow from, the lending
function. Obviously, loans are a primary use of funds. And while controlling loan
growth has always been a large part of liquidity management, historically the loan
portfolio has not been viewed as a significant source of funds for liquidity
management. Practices are changing, however. Banks can use the loan portfolio as a
source of funds by reducing the total dollar volume of loans through sales,
securitization, and portfolio run-off.
In fact, banks are taking a more active role in managing their loan portfolios. While
these activities are often initiated to manage credit risk, they have also improved
liquidity. Banks increasingly are originating loans “for sale” or securitization.
Consumer loans (mortgages, installment loans, and credit cards) are routinely
originated for immediate securitization. Many larger banks have been expanding
their underwriting for the syndicated loan market. Additionally, banks are also

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expanding the packaging and sale of distressed credits and otherwise undesirable
loans. As part of liquidity planning, a bank’s overall liquidity strategy should include
the identification of those loans or loan portfolio segments that may be easily
converted to cash. A loan’s liquidity hinges on such characteristics as its quality,
pricing, scheduled maturities, and conformity to market standards for underwriting.
Loans are also a source of liquidity when used as collateral for borrowings. The ease
with which a bank can participate or sell loans to other lenders or investors (and the
terms on which the bank can do so) will vary with market conditions, the type of
loan, and the quality of loan. Information provided for liquidity analysis should
include an assessment of these variables under various scenarios. Liquidity is also

affected by the amount of the bank’s commitments to lend and the actual amount that
borrowers draw against those commitments. A bank should have systems to track
commitments and borrower usage.
Knowledge of the types of commitments, deals in the pipeline, normal usage levels,
and historically high usage levels are important in assessing whether available
liquidity will be adequate for normal, seasonal, or emergency needs. Management
information systems should distinguish between commitments that the bank is
legally obligated to fund and those (guidance or advisory lines) that it is not. Any
analysis of a bank’s ability to reduce or cut existing commitments must consider
more than its legal obligation to lend. It should also consider reputation risk and the
potential for lender-liability actions. The withdrawal or reduction of commitments
can have significant ramifications for a bank. From a strategic perspective, any
tightening of commitments may adversely affect a bank’s ability to maintain or grow
a customer base if it is perceived as an unreliable lender in tight credit markets. A
bank’s reputation may also suffer if it is perceived as unwilling to support
community credit needs. Given these ancillary risks, bank management must
carefully assess the implications of curtailing lending lines.
Price Risk
Most of the developments that improve the loan portfolio’s liquidity have
implications for price risk. Traditionally, the lending activities of most banks were
not affected by price risk. Because loans were customarily held to maturity,
accounting doctrine required book value accounting treatment. However, as banks
develop more active portfolio management practices and the market for loans
expands and deepens, loan portfolios will become increasingly sensitive to price risk.

17


Loans originated for sale as part of a securitization or for direct placement in the
secondary market carry price risk while they are in the pipeline awaiting packaging

and sale. During that period, the assets should be placed in a “held-for-sale” account,
where they must be repriced at the lower of cost or market. The same accounting
treatment can apply to syndicated credits and distressed loans. When a bank
underwrites a larger portion of a syndicated loan than its “hold” position, the excess
portion must be placed in a held-for sale account. Once a sale strategy is adopted for
distressed or otherwise undesirable credits, those credits should also be placed in a
held-for-sale account.
Banks engaged in international lending may be affected by price changes in the
secondary market for such loans. Each month, banks that actively trade foreign debt
must mark to market the loans in their trading account.
Foreign Exchange Risk
Foreign exchange risk is present when a loan or portfolio of loans is denominated in
a foreign currency or is funded by borrowings in another currency. In some cases,
banks will enter into multi-currency credit commitments that permit borrowers to
select the currency they prefer to use in each rollover period. Foreign exchange risk
can be intensified by political, social, or economic developments. The consequences
can be unfavorable if one of the currencies involved becomes subject to stringent
exchange controls or is subject to wide exchange-rate fluctuations.
Transaction Risk
In the lending area, transaction risk is present primarily in the loan disbursement and
credit administration processes. The level of transaction risk depends on the
adequacy of information systems and controls, the quality of operating procedures,
and the capability and integrity of employees. Significant losses in loan and lease
portfolios have resulted from inadequate information systems, procedures, and
controls. For example, banks have incurred increased credit risk when information
systems failed to provide adequate information to identify concentrations, expired
facilities, or stale financial statements. At times, banks have incurred losses because
they failed to perfect or renew collateral liens; to obtain proper signatures on loan
documents; or to disburse loan proceeds as required by the loan documents.

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Compliance Risk
Lending activities encompass a broad range of compliance responsibilities and risks.
By law, a bank must observe limits on its loans to a single borrower, to insiders, and
to affiliates; limits on interest rates; and the array of consumer protection and
Community Reinvestment Act regulations. A bank’s lending activities may expose it
to liability for the cleanup of environmental hazards. A bank may also become the
subject of borrower-initiated “lender liability” lawsuits for damages attributed to its
lending or collection practices. Supervisory activities should include the review of
the bank’s internal compliance process to ensure that examiners identify and
investigate compliance issues.
Strategic Risk
A primary objective of loan portfolio management is to control the strategic risk
associated with a bank’s lending activities. Inappropriate strategic or tactical
decisions about underwriting standards, loan portfolio growth, new loan products, or
geographic and demographic markets can compromise a bank’s future. Examiners
should be particularly attentive to new business and product ventures. These ventures
require significant planning and careful oversight to ensure the risks are
appropriately identified and managed. For example, many banks are extending their
consumer loan activities to “subprime” borrowers. The product may be familiar, but
the borrowers’ behavior may differ considerably from the banks’ typical customer.
Do they understand the unique risks associated with this market, can they price for
the increased risk, and do they have the technology and MIS to service this market?
Moreover, how will they compete with the nonbank companies who dominate this
market? Both bankers and examiners need to decide whether the opportunities
outweigh the strategic risks. If a bank is considering growing a loan product or
business in a market saturated with that product or business, it should make sure that
it is not overlooking other lending opportunities with more promise. During their

evaluation of the loan portfolio management process, examiners should ensure that
bankers are realistically assessing strategic risk.
Reputation Risk
When a bank experiences credit problems, its reputation with investors, the
community, and even individual customers usually suffers. Inefficient loan delivery
systems, failure to adequately meet the credit needs of the community, and lender-

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liability lawsuits are also examples of how a bank’s reputation can be tarnished
because of problems within its lending division.
Reputation risk can damage a bank’s business in many ways. The value of the bank’s
stock falls, customers and community support is lost, and business opportunities
evaporate. To protect their reputations, banks often feel that they must do more than
is legally required. For example, some banks have repurchased loan participations
when credit problems develop, even though these problems were not apparent at the
time of the underwriting.
1.5. International Experience on Loan Management
1.5.1. Major Causes of Problem Loans
The causes of problem loans range from poor plant management or increasing raw
materials costs in the case of a manufacturer to poor accounts receivable collection
policies or a rise in the price of products in the case of wholesale company. Most often,
a problem loan is the result of not one, but several factors.
Poor Loan Interview: Avoiding problem loans begins with a thorough evaluation of
the loan request and an equally committed follow-up effort. Any significant breakdown
in the commercial lending process, from a poor loan interview to inadequate
monitoring, may result in a band loan.
A poor interview most often occurs when the business banker is dealing with a friend
or when the business owner has leverage. Rather than ask tough, probing questions

about the company’s financial situation, the business banker opts for friendly banter
instead. Sometime a relationship manager may be intimidated or conned. The business
banker may be reluctant to ask questions for fear of sounding dumb or appearing to
lack basic knowledge of the company or industry. For whatever reason, he or she may
allow a loan request that should have been rejected during the initial interview to
proceed to financial analysis and beyond. With each subsequent step, it becomes
increasingly more difficult to reject the request.
Inadequate Financial Analysis: Many loans become problems when a commercial
loan officer considers the financial analysis unimportant and believe that, instead, the
true test of whether a loan will be repaid lies in a handshake, the eyes, or some other
subjective measures of the client. Although some characteristics, such as the ability to

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overcome adversity, do not appear on financial statement, there is no substitute for a
complete analysis of income statement, balance sheet, ratios, cash flow, and so forth.
Together, they present an objective measure of performance that can be compared with
those of similar companies.
Improper Loan Structuring
Another cause of problem loans is the failure of the business banker to structure the
loan properly. Problems often arise when business banker fails to understand the
client’s business and the cash flow cycle. Without this knowledge, it is difficult to
anticipate future financing needs and to choose the appropriate loan type, amount, and
repayment terms. Most borrowers, regardless of financial health, find it difficult to
repay debts that do not coincide with their cash flow cycle.
Improper Loan Support
Another leading cause of loan loss is improper collateralization. Accepting collateral
not properly evaluated for ownership, value, or marketability can leave the bank
unprotected in a default case. Collateral Security by way of mortgage of immovable

property or other fixed assets, thereby creating a charge, trains the mind of the
borrower to be prepared to pay the dues to the lenders. But when he is free from this
fear of losing his encumbered asset in the event of his defaulting in the payment of
dues to banks and financial institutions, he often takes the liberty, and tends to weigh
the pros and cons vis-à-vis default. Security against loan, though at times may fall
harsh on the borrower, serves a worthwhile purpose in that it creates promoters' stake in
the borrowers and thus, disciplines the borrower to be more committed in paying the
due to banks and FI.
Unrealistic Terms and Schedule of Repayment
Occasions are not few when there develops a tendency on the part of the financers to
paint a rosy picture of the project at the time of appraisal. If the sanctioning authority is
guided by considerations of personal interests, many things may happen. The
breakeven point of a project may be shown at an unrealistically low level of operation,
or profitability may be shown at an unduly high level just to brighten the chances of
acceptability of the project by the financial institution; or cash inflow may be shown in
an unduly optimistic manner and, therefore, Debts Service Coverage Ratio (DSCR)
worked out incorrectly, fixing unrealistically high installments and conservative

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schedule of repayments. These inner pulls and pressures may find reflection in fixing
excessive amounts of installments in order to show an early period of repayment. The
borrower at this stage finds himself in an unenviable position of a 'Yes Master' and
nods his head at whatever conditions are attached or whatever repayment schedule is
fixed by the financial institutions, in all probability, covering up his design to evade
payment of the future dues. And, the real problem surfaces when repayment of
installment/payment of interest falls due and the borrower conveniently and blissfully
ignores calls for clearance of the said dues, not so much due to his intention to defraud
the loans, as due to him already bleeding white to keep his concern going.

Fluctuations in Statutory Regulations and Norms
Certain unforeseen, unpredictable and unexpected fluctuations in the statutory
regulations such as change in the Excise rates, Commercial Tax, Electricity Tariff and
other revenue tools of the government, tend to throw the entire planning of the
industrialist out of gear. It has been observed that these fluctuations are of such a
magnitude and are so unpredictable as to be beyond the comprehension of the most
skeptic and apprehensive of entrepreneur. In order to cope with these unforeseen
variations, which force the entrepreneur to put additional burden on his financial
resources, the natural and convenient remedy that comes to his mind is to delay the
repayment of the loan.
Lack of Follow up Measures
Follow-up measures taken regularly and systematically keep the borrowing unit under
constant vigil of the financial institution. Many ills can be checked through such
follow-up measures by keeping the borrowing units on their alertness and guiding them
to rectify their mistakes in the first opportunities or extending them a helping hand in
tiding over their tight times. Normally, such close follow-up programs are conspicuous
by their absence. In the result, the borrowing units not only ignore payment of their
dues to financial institutions but also often tread on wrong tracks, much to the
detriment of their own financial health and that of the financial institutions.
Performance of the borrowing units, if carefully and systematically monitored through
regular inspections by scrutiny of returns, annual balance sheet and inspection of site,
can be significantly improved. Naturally, such inspections prevent the borrowers from
deviating from the terms and conditions of the loan or from diverting any fund for

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purpose other than those earmarked in the sanction letter and keep the financial health
of the units in good order.
1.5.2. Detecting Problem Loans

Loans rarely become problem loans or losses overnight. Usually, numerous warning
signs precede a gradual deterioration in credit quality. If detected in time, the business
banker acts to prevent the problem loan from developing or at least moves to minimize
bank loss dif a default does occur. For example, suppose a manufacturer of musical
instruments fails to invest enough in product research over the years and, as a result, its
line of pianos and keyboards becomes obsolete. The company is headed for
bankruptcy, with potential sizable losses for its creditors. The extent of the bank’s loss
depends, to a large degree, on the ability of its relationship manager to spot warning
signs and act before bankruptcy papers are filed. One obvious sign is the decline in the
company’s financial commitment to product research and development. The growing
obsolescence of its instruments likely would appear on the company’s financial
statements as declining sales and a slowdown in inventory turnover. If calls to the
company president go unreturned, or if a sharp decline in bank account balance occurs,
or financial statements stop coming altogether, the relationship manager can conclude
that a problem loan has occurred.
The key to minimizing problem loans is to note the symptoms when they occur, rather
than wait for a major breakdown in repayment. Early recognition of problem loans
gives the relationship manager an opportunity to work with the borrower and take some
type of remedial action before a loan workout or loss becomes inevitable. To detect
problem loans at an early stage, the relationship manager should:


Analyze financial statements regularly and thoroughly



Keep lines of communication open with the borrower with frequent telephone calls,
correspondence, and site visits.



Stay alert to direct or indirect signs supplied by third parties



Look at the borrower’s total account relationship with the bank

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Financial Statement Warning signs
Analyzing the borrowers financial statement s will reveal many of the symptoms of a
potentially problem credit. As recommended earlier, the major tools of financial
analysis are the income statement, balance sheet, ratios and cash flow statement.
Comparing income statements and balance sheets from year to year (or period to
period) or to some external standard (or company to company) would be very helpful
in detecting financial weakness of the borrower which may lead to borrower’s default.
Third Party Warning Signs
Business transactions or other personal contacts between the borrower and third parties
often alert a relationship manager to potential problem loans. Bank tellers or clerks,
who handle the company’s transactions, may be familiar with how the company is run.
The first sign of trouble could come from the bank clerk who notices that the company
is relying on float and large last-minute deposits to cover its payroll. The company’s
competitors, suppliers, customers, and regulators can alert the inquisitive relationship
manager to an impending problem or, perhaps, provide some missing background
information. List of some warning signs from third-party sources may include but not
limited to:


Calls from existing suppliers for additional credit information to evaluate requests

for special terms



Calls from new suppliers requesting credit information to open new credit lines



Appearance of other FIs in the lending picture, especially collateralized lenders



An Insurance Company that send a cancellation for non-payment of a premium



Legal notice served against the borrower for tax liens, judgments or garnishments

An occasional check of public records and a daily perusal of newspapers, magazines
and trade publications may reveal warning signs. A newspaper or magazine article may
be the first place a business banker learns of a contract termination, plant closing, or
some other event that may foretell a problem loan. Public records show if other
creditors have filed liens on the company’s assets and, if so, who filed and why they

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