Principles and Practice of Bank Lending

Question 1

What is Lending?

Answer 1

Lending can be defined as the giving of an asset with the expectation that an equivalent value will be returned at a future point in time.

Question 2

What is a Loan?

Answer 2

A loan is an asset for the lender and a liability for the borrower. From the lender’s perspective, the loan is an asset that is expected to be repaid with compensation for the costs and risks of lending. From the borrower’s perspective, the loan is a liability that requires to be repaid with compensation for the costs of receiving the benefits of borrowing.

Question 3

What is the Bank Rate?

Answer 3

Bank Rate is the interest rate at which a nation’s central bank lends money to domestic banks, often in the form of very short-term loans.

Managing the bank rate is a method by which central banks affect economic activity. Lower bank rates can help to expand the economy by lowering the cost of funds for borrowers, and higher bank rates help to rein in the economy when inflation is higher than desired.

Question 4

What is Capped Interest?

Answer 4

Capped interest is where, although interest rates can fluctuate, they are subject to a specified ceiling, or ‘interest cap’.

Question 5

What is Simple Interest?

Answer 5

Simple interest is where there is no compounding of interest; interest is determined simply by multiplying the principal by the rate by the number of time periods. Interest charged on a loan of £1,000 taken over 12 months at a simple rate of 12% per annum would therefore be £120 (£10 a month).

Question 6

What is Compound Interest?

Answer 6

Compound interest is interest on the principal amount plus whatever interest has already accrued.

There are two factors that add up to make compound interest: interest paid on the principal, and interest paid on accrued interest.

Principal is the amount borrowed or invested, and interest is a percentage cost or profit based on the principal amount. In practice, compound interest works by calculating interest on an entire balance, including past interest that’s been added to the balance.

Question 7

What is Standard Variable Rate (SVR)?

Answer 7

The standard variable rate (SVR) is the standard rate of interest that lenders use, and is the rate to which a borrower is usually automatically switched when any fixed or initial offer rate period expires. In the UK, this rate is usually a few percentage points higher than Bank Rate, to which it is linked, meaning it varies with changes in Bank Rate.

Question 8

What is the Annual Equivalent Rate (AER)?

Answer 8

The annual equivalent rate (AER), for savings and current accounts in credit, and the effective annual rate (EAR), for borrowing and overdrafts, are annualised rates of interest, including the compounding effect of charging or paying interest more frequently than once a year. The more frequently interest is applied during a year, the higher the effective annual rate will be.

Question 9

What is the Annual Percentage Rate (APR)?

Answer 9

In the UK, the annual percentage rate (APR) is the annualised interest rate, including the effects of both compounding interest and other (non-interest) charges, e.g., an annual fee. In the US, the APR does not take into account the effect of compounding interest.

Question 10

What else might a lend do (as well as interest)?

Answer 10

As well as charging interest, lenders may also charge fees to cover their expenses and generate profit, for example

• An arrangement fee for arranging the loan
• A valuation fee for valuing a borrower’s assets, e.g., their property
• Legal fees associated with arranging the loan
• A higher lending charge — a fee charged by some mortgage lenders where the amount borrowed exceeds a given percentage of the value of the property. This fee may be used by the lender to buy an insurance policy that protects it against loss in the event that the borrower is unable to repay their mortgage, and the lender has to sell the property at a loss.

Question 11

What is the link between Risk & Return?

Answer 11

The higher the risk, the higher the return the lender will require. That’s why lenders charge higher interest rates for high-risk loans — if the borrower is unable to repay their loan further down the line, the interest already paid on the loan can reduce the lender’s loss.

A key point is that risk is about dealing with uncertainty; it’s about calculating how likely it is that an event, such as a loan not being repaid, might happen, as well as the impact of that event in terms of the potential harm it could cause to the bank, its customers, and even the economy

Question 12

What is the Standards of Lending Practice?

Answer 12

The Standards of Lending Practice were introduced by the UK’s Lending Standards Board, becoming effective in October, 2016. The Lending Standards Board (LSB) works to a single, clear remit: to promote fair lending. Its vision is to ensure that all personal and small business borrowers receive a fair deal from their lender as set out in the Standards of Lending Practice (LSB, 2019). The Standards are voluntary and set the benchmark for good lending practice in the UK, outlining the way registered firms are expected to deal with their customers throughout the entire product life cycle.

Question 13

What does each Standard contain?

Answer 13

a customer outcome

an overall statement of how a firm intends to achieve this outcome

a detailed set of standards that demonstrate the approach.

A separate section covers governance and oversight, setting out the framework firms should have in place to ensure that the Standards are implemented and operate effectively.

Recognising that there is more than one way to achieve fair customer outcomes, the Standards provide a level of flexibility, allowing firms to tailor their practice around a customer’s individual circumstances.

Question 14

What are the six main areas the Standards of Lending Practice covers for Personal Customers?

Answer 14

• Financial promotions and communications
• Product sale
• Account maintenance and servicing
• Money management
• Financial difficulty
• Consumer vulnerability

Question 15

What are the eight main areas the Standards of Lending Practice covers for Business Customers?

Answer 15

• Product information
• Product sale
• Declined applications
• Product execution
• Credit monitoring
• Financial difficulty
• Portfolio management
• Vulnerability.

Question 16

When does a business customer qualify for the protection of the Standards of Lending Practice?

Answer 16

The protections of the Standards of Lending Practice for business customers apply to a business which, at the point of lending:

• has an annual turnover of up to £6.5 million (increasing to £25 million with effect from 1st November, 2019) in its last financial year (exclusive of VAT and other turnover-related taxes)
• does not have a complex ownership structure (for example, businesses with overseas, multiple, or layered ownership structures).

Question 17

What is the Lending Cycle?

Answer 17

a loan facility has a life cycle, which means that lenders are unable to determine the profitability of an individual loan until it has been fully repaid. Although annual profits can be estimated, these could be adversely affected by subsequent losses on loans previously thought to be safe and secure.

The lending cycle has a number of different stages through which a loan travels during its ‘life’

Question 18

What are the Principles of Lending?

Answer 18

The principles, or ‘canons’, of lending — the principles that help a bank to mitigate the key risks when granting credit — are the essential criteria on which responsible lending decisions are made. These principles are generic and apply to personal, small business, and corporate customers.

The principles of lending are captured in various mnemonic devices, providing a framework for lenders to use when evaluating an application for credit and gathering the information required to make a lending decision

Question 19

What does CAMPARI stand for?

Answer 19

Character – borrower’s integrity, credit history and background

Ability - about the managerial and technical competence of a business owner or those managing the business.

Means - about establishing the borrower’s means. It involves looking at what assets they have and their liabilities — their financial obligations. As well as helping the credit assessment.

Purpose - What does the customer want the money for? It must be legal, ethical, relevant and in line with the bank’s lending policy. It is also important to establish the level of risk it involves.

Amount - borrowers may feel they have a need to borrow, they may not accurately calculate how much they need.

Repayment – can come in the form of two ways:
• Income, e.g., a personal customer’s salary, or a business’s sales/profit
• Sale of an asset, or maturation of an endowment policy.

From the lender’s perspective, knowing if they are dealing with short-term, medium-term or long-term borrowing will help the lender manage its own assets and liabilities and the risks involved.

Insurance - need to consider: Is security offered? What type of security is it? Is it valuable enough to repay the loan if required?

Question 20

What does ICE stand for?

Answer 20

ICE is the criteria that indicate whether the lending proposition will be of benefit to the bank. It includes:

• Interest
• Commission and fees (charges)
• Extras: about whether there are any other relevant products that could be offered to the customer, such as private banking or insurance. E.g. life cover, payment protection insurance.

Question 21

What are the 3 C’s?

Answer 21

Character, Capability, Capital

Question 22

What are the 4 C’s?

Answer 22

Character, Capability, Capital, Connection

Question 23

What does IPARTS stand for?

Answer 23

Integrity, Purpose, Amount, Repayment, Terms, Security

Question 24

What does PARSERS stand for?

Answer 24

Person, Amount, Repayment, Security, Expediency, Remuneration, Services

Question 25

What is Credit Scoring?

Answer 25

If we are already a customer of the bank, it will also check how well we have managed our finances with them in the past. For example, if we have made previous loan and credit card payments on time, have borrowed responsibly, have managed our finances well, and have the means and capacity to repay the credit that we are now applying for, the bank is likely to look favourably on our application. If, however, we have a history of making late payments, or regularly exceeding our overdraft or credit card limit, this is highly likely to adversely affect our chances of gaining any further credit. Our credit ‘character’ would not be looking good, and the bank would not be acting in either its or our best interests by lending us money that the evidence suggests we couldn’t afford to repay.

Question 26

What is a FICO® Score?

Answer 26

FICO® Scores are calculated using many different pieces of information in the credit report. The information is grouped into five categories:

Payment history
Amounts owed
Length of credit history
New credit
Credit mix.

A weighting is allocated to each category.

Question 27

When Banks are making a decision to lend, they use…

Answer 27

• the information we have provided on our application for credit
• their analysis of our past behaviour with them
• the information provided by the credit reference agency

Question 28

What are the types of Security (which include assets)?

Answer 28

Types of security include assets, such as:

• Land
• Properties built on the land
• Life assurance policies
• Stocks and shares.

Question 29

What is a Guarantee?

Answer 29

Another type of security is a guarantee. A guarantee is a promise made by a person or a company (the guarantor) to assume the debt obligation of a borrower if that borrower fails to pay what is due. This means that, if a customer is no longer able to repay their loan, the lender can pursue the guarantor for repayment of the debt. However, a guarantee has no real value until it is called upon and, because a bank cannot always be certain that the guarantor will pay the amount due, guarantees are often supported with asset-based securities, which means that the guarantor puts up their own assets as security, or collateral, for the loan.

Question 30

What does MAST stand for?

Answer 30

One way of evaluating the effectiveness of an asset as security is known as the ‘MAST test’

MAST stands for:

• Marketability – how easy it is to sell the asset
• Ascertainability of value – how easy it is to value accurately
• Simplicity of title – how easily ownership can be proved
• Transferability of title – how easy it is for the bank to gain ownership so that it can sell the asset.

Question 31

What are the benefits to society for Responsible Lending?

Answer 31

• drives economic growth through the credit creation process (see Unit 1)
• leads to more efficient allocation and utilisation of resources in the economy
• stimulates higher levels of saving (due to banks using some of the money they earn from lending to pay interest to savers, who are effectively lending their money to the bank so that the bank can lend some of that money to others)
• makes money available for supporting socially and environmentally sustainable economic activities
• makes funds available at low cost to disadvantaged sections of society, through social/peer-to-peer lending

Question 32

What are the detrimental effects to society for responsible lending?

Answer 32

• Lending can also have detrimental effects on the economy. Irresponsible lending can encourage irresponsible borrowing, where customers borrow more than they can afford and find that they are unable to repay their loans. Not only does this adversely affect the customer, the bank also loses out when loans are not repaid.
• Lending can also accentuate social inequalities, where borrowers who are perceived as high-risk are charged higher rates of interest, trapping them in higher debt burdens.