CHAPTER 6

Question 1

THE ROLE OF ASYMMETRIC
INFORMATION IN LENDING (3)

Answer 1

o Asymmetric Information
o Adverse Selection
o Moral Hazard

Question 2

The inequality of information between the bank and the borrower

Answer 2

Asymmetric Information

Question 3

Means that the borrowers have more information about themselves than is available to the bank

Answer 3

Asymmetric Information

Question 4

The average interest rate is too high for borrowers with low-risk investment projects and too low for borrowers with high-risk investment projects

True or False

Answer 4

True

Question 5

Means that high-risk borrowers try to get loans from banks because they are willing to pay the average rate of interest, which is less than they would have to pay if their true condition were known to the bank

Answer 5

Adverse Selection

Question 6

It also follows that low-risk creditworthy borrowers may be able to borrow directly from the money and capital markets at lower rates
than those offered by banks.

Answer 6

Adverse Selection

Question 7

Is the base rate on corporate loans made by banks

Answer 7

Prime Rate

Question 8

Is the risk that the borrower, who now has the loan, might use the funds to engage in higher risk activities in expectation of earning higher returns

Answer 8

Moral Hazard

Question 9

Is most likely to occur when the lender is unable to monitor the borrower’s activities

Answer 9

Moral Hazard Problem

Question 10

THE COMPETITIVE ENVIRONMENT (3)

Answer 10

o The Business in Lending
o Increasing Competition
o Changes in Technology

Question 11

Changes in Technology (3)

Answer 11

• Securitization of loans
• Credit scoring
• Electronic banking

Question 12

Is the risk to earnings and capital that a borrower or counterparty may not meet the terms of the loan contract, resulting in losses to
the lender

Answer 12

Credit Risk

Question 13

Applies to loans, derivatives, foreign exchange transactions, the investment portfolio, and other

Answer 13

Credit Risk

Question 14

tells us that the expectation of high returns attracts competition, and the loan business is no exception

Answer 14

Economic Theory

Question 15

are conditions in the loan contract that the borrower must meet

Answer 15

Loan Covenants

Question 16

Is packaging and selling otherwise unmarketable loans to other financial institutions and investors

Answer 16

Securitization

Question 17

means that loans that were formerly funded in local markets are now being funded in global capital markets

Answer 17

Growth of securitization

Question 18

Today, the lending process can be divided into the following four (4) activities:

Answer 18

1. Originating loans.
2. Packaging loans for sale to others.
3. Servicing loan portfolios.
4. Investing in loan-backed credit instruments.

Question 19

Syndication of any loan or loan commitment of at least $20 million that is shared by three or more unaffiliated federally supervised institutions, or a portion of which is sold to two or more unaffiliated federally supervised institutions

Answer 19

Shared National Credit (SNC)

Question 20

From the borrower’s point of view, syndication provides more funds than may be available from
any single lender. From the lender’s point of view, syndication provides a means of diversifying some
of the risks of foreign lending

True or False

Answer 20

True

Question 21

can enhance relations with foreign governments because it is a means of financing their domestic economic activity

Answer 21

Syndication

Question 22

is the use of statistical models to determine the likelihood that a prospective borrower will default
on a loan

Answer 22

Credit Scoring

Question 23

has the ultimate responsibility for all of the loans made by their bank

Answer 23

Board of directors

Question 24

who has the authority to make loans. The lending limits relative to capital, deposits, or assets. The loan approval process

Answer 24

Loan Authority

Question 25

the types of loans the bank wants to make, such as consumer loans, loans to start up businesses, loans to large businesses, farm loans, or international loans

Answer 25

Loan Portfolio

Question 26

Reducing Credit Risk (7)

Answer 26

1. Avoid making high-risk loans 2. Collateral reduces the risk to the lender 3. Diversify the loan portfolio 4. Documentation 5. Limit the amount of credit extended 6. Monitor the behavior of the borrower 7. Transfer risk to other parties

Question 27

is considered a secondary source of repayment in the event of loan default.

Answer 27

Collateral

Question 28

means making investments or loans to a variety of borrowers whose cash flows are not perfectly positively correlated and avoiding undue concentration to a borrower or in a particular type of loan whose returns are related

Answer 28

Diversification

Question 29

refers to all of the documents needed to legally enforce a loan contract and protect a bank’s interest

Answer 29

Documentation

Question 30

Documents typically include: (5)

Answer 30

- promissory notes, - guarantees - financial statements - UCC (Uniform Commercial Code) filings for collateral - notes about meetings with the customers

Question 31

refers to the ability of the lender (the principal) to influence the behavior of the borrower (the agent).

Answer 31

Agency problems

Question 32

SEVEN WAYS TO MAKE LOANS

Answer 32

1. Banks Solicit loans 2. Buying Loans 3. Commitments 4. Customers Request Loans 5. Loan Brokers 6. Overdrafts 7. Refinancing

Question 33

Banks buy parts of loans from other banks

Answer 33

Participations

Question 34

is an agreement between a bank and a firm to lend funds under terms that are agreed on in writing

Answer 34

Loan commitment

Question 35

are individuals or firms who act as agents or brokers between the borrower and the lender

Answer 35

Loan brokers

Question 36

occurs when a customer writes a check on uncollected funds or when there are insufficient funds in the account to cover the withdrawal

Answer 36

Overdraft

Question 37

Overdrafts can be for less than one day when a check is written or funds transferred out by wire in the morning and the deposit to cover that check or wire transfer is not made until that afternoon

Answer 37

Daylight Overdraft

Question 38

Two (2) primary sources of repayment that lenders consider when they make loans:

Answer 38

1. from the borrowers’ cash flow (e.g., earnings) 2. from the sale of the assets being financed (e.g., inventory)

Question 39

TYPES OF LOANS (4)

Answer 39

- line of credit - revolving loans - term loans - bridge loans

Question 40

The total assets of a firm can be divided into two (2) categories

Answer 40

- permanent assets - temporary assets

Question 41

include plant and equipment as well as that portion of working capital (cash, accounts receivable, and inventory) that will be sustained over time.

Answer 41

Permanent assets

Question 42

include that portion of working capital that fluctuates with periodic changes in sales and revenues

Answer 42

Temporary assets

Question 43

agreements which may or may not result in loans

Answer 43

Credit facilities

Question 44

is an agreement between a customer and the bank that the bank will entertain requests from that customer for a loan up to a predetermined amount

Answer 44

Line of credit

Question 45

is established when the bank gives a letter to the customer stating the dollar amount of the line, the time it is in effect (e.g., 1 year), and other conditions or provisions, such as the relationship the customer must maintain with the bank and the customer’s financial condition

Answer 45

Line of credit

Question 46

is the maximum amount that can be borrowed under the terms of the loan

Answer 46

Line of credit

Question 47

are similar to a line of credit because they, too, are used to finance borrowers’ temporary and seasonal working capital needs

Answer 47

Revolving loans

Question 48

commonly specify the minimum amount of the increments that may be borrowed

Answer 48

Revolving loans

Question 49

Another difference is that revolving loans usually have a maturity of two years or more, while lines of credit are usually for shorter periods. True of False

Answer 49

True

Question 50

is usually a single loan for a stated period of time or a series of loans on specified dates

Answer 50

Term loan

Question 51

is used for a specific purpose, such as acquiring machinery, renovating a building, or refinancing debt

Answer 51

Term loan

Question 52

It should not be used to finance day-to-day operations

Answer 52

Term loan

Question 53

bridge a gap in a borrower’s financing until some specific event occurs

Answer 53

Bridge loans

Question 54

is a form of commercial lending where the assets of a company are used to secure the company’s obligation to the lender

Answer 54

Asset-based lending

Question 55

require a higher level of monitoring than other secured commercial loans

Answer 55

Asset-based loans

Question 56

is a contract that enables a user (the lessee) to secure the use of a tangible asset over a specified period of time by making payments to the owner (the lessor)

Answer 56

Lease

Question 57

are used to finance tangible assets such as cars, airliners, and ships

Answer 57

Lease

Question 58

Two types of leases:

Answer 58

- operating leases - financial leases

Question 59

are short-term leases used to finance equipment such as computers, where the term of the lease is a fraction of the economic life of the asset

Answer 59

Operating leases

Question 60

are used in connection with financing long-term assets and have a term that is equal to the economic life of the asset

Answer 60

Financial leases

Question 61

refers to an asset pledged against the performance of an obligation reduces the bank’s risk when it makes a loan

Answer 61

Collateral

Question 62

CHARACTERISTICS OF GOOD COLLATERAL (5)

Answer 62

- durability - identification - marketability - stability of value - standardization

Question 63

This refers to the ability of the asset to withstand wear or to its useful life. Durable goods make better collateral than nondurables

Answer 63

Durability

Question 64

Certain types of assets are readily identifiable because they have definite characteristics or serial numbers that cannot be removed

Answer 64

Identification

Question 65

For collateral to be of value to the bank, the collateral must be marketable

Answer 65

Marketability

Question 66

TYPES OF COLLATERAL (6)

Answer 66

- accounts receivable - nonrecourse - inventory - marketable securities - real property and equipment - guarantees

Question 67

There are three ways that accounts receivable can be used as collateral:

Answer 67

- pledging - factoring - bankers’ acceptances

Question 68

A borrower can pledge accounts receivable with his or her bank

Answer 68

Pledging

Question 69

is the sale of accounts receivable to a factor, which is usually a bank or finance company

Answer 69

Factoring

Question 70

means that it cannot be returned to the firm that is selling the receivables

Answer 70

Nonrecourse

Question 71

usually arises from foreign trade

Answer 71

Bankers' acceptance

Question 72

is widely used as collateral against commercial loans. The inventory may consist of raw materials or finished goods, such as automobiles. Other types of inventory may include natural resources, livestock, and crops.

Answer 72

Inventory

Question 73

including corporate stocks and bonds, certificates of deposit, and U.S. Treasury securities may be used as collateral for business loans

Answer 73

Marketable securities

Question 74

Real property refers to real estate that includes houses, office buildings, shopping centers, and factories.  Such property is widely used as collateral.  equipment of various sorts may be used.  Equipment includes trucks, forklifts, drill presses, and robotics

Answer 74

Real property and equipment

Question 75

Bankers can improve their security by having a third party guarantee the payments

Answer 75

Guarantees

Question 76

THE LENDING PROCESS Six C’s of credit:

Answer 76

1. Character 2. Capacity 3. Capital 4. Collateral 5. Conditions 6. Compliance

Question 77

 refers to a combination of qualities that distinguishes one person or a group from another  refer to a borrower’s honesty, responsibility, integrity, and consistency, on which we can determine willingness to repay loans

Answer 77

Character

Question 78

 This refers to success of the borrower’s business as reflected in its financial condition and ability to meet financial obligations via cash flow and earnings  the borrower’s success in running a business—cash flows

Answer 78

Capacity

Question 79

 represents the amount of equity capital a firm has that can be liquidated for payment if all other means of collection of the debt fail  (the financial condition of the borrower—net worth

Answer 79

Capital

Question 80

is equal to total assets less total liabilities

Answer 80

Equity capital

Question 81

 refers to assets that are pledged for security in a credit transaction  pledged assets

Answer 81

Collateral

Question 82

compliance with laws and regulations

Answer 82

Compliance

Question 83

promises by the borrower to take or not take certain actions during the term of the loan

Answer 83

Covenants