544 Part Six Providing Loans to Businesses and Consumers

17-2 Brief History of Business Lending )

Commercial and industrial (or business) loans represented the earliest form of lending that
banks carried out in their more than 2,000-year history. Loans extended to ship owners,
mining operators, goods manufacturers, and property owners dominated bankers' loan
portfolios for centuries. Then, late in the 19th and early 20th centuries new competitors
particularly finance companies, life and property/casualty insurance firms, and some thrift
institutionsentered the business lending field, placing downward pressure on the profit
margins of many business lenders. In today's world, loan officers skilled in evaluating the
credit requests of business firms rank among the most experienced and highest-paid people
in the financial-services field, along with investment bankers (security underwriters), who
also provide funds to the business sector.

17-3 Types of Business Loans )

Banks, finance companies, and competing business lenders grant many different types of
commercial loans. Among the most widely used forms of business credit are the following:
Key URL
To learn more about helpful
procedures in applying for
small business loans, see, in
particular, www.
business.com/directory
.

Short-Term Business Loans

Long-Term Business Loans

Self-liquidating inventory loans

Working capital loans
Interim construction financing
Security dealer financing
Retailer and equipment financing
Asset-based loans (accounts receivable
financing, factoring, and inventory
financing)

Term loans to support the purchase

of equipment, rolling stock, and
structures
Revolving credit financing
Project loans
Loans to support acquisitions of
other business firms

17-4 Short-Term Loans to Business Firms )

Self-Liquidating Inventory Loans
Historically, commercial banks have been the leaders in extending short-term credit to businesses. In fact, until World War II banks granted mainly self-liquidating loans to business
firms. These loans usually were used to finance the purchase of inventoryraw materials or
finished goods to sell. Such loans take advantage of the normal cash cycle inside a business
firm:
1.Cash (including borrowed cash) is spent to acquire inventories of raw materials and
semifinished or finished goods.
2.Goods are produced or shelved and listed for sale.
3.Sales are made (often on credit).
4.The cash received (immediately or later from credit-sales) is then usedto repay-the self
_________________________________________________________________________
liquidatingloan.
In this case, the term of the loan begins when cash is needed to purchase inventory and ends
(perhaps in 60 to 90 days) when cash is available in the firm's account to write the lender a
check for the balance of its loan.
While most lenders today make a far wider array of business loans than just simple self-

liquidating credits, the short-term loanfrequently displaying many of the features of selfliquidationcontinues to account for a significant share of all loans to business firms.

Chapter 17 Lending to Business Firms and Pricing Business Loam 545

In fact, most business loans cover only a few weeks or months and are usually related
closely to the borrower's need for short-term cash to finance purchases of inventory or
cover production costs, the payment of taxes, interest payments on debt, and dividend
payments to stockholders.
There is concern in the banking and commercial finance industries today that traditional
inventory loans may be on the decline. Thanks to the development of just in time (JIT) and
supply chain management techniques businesses can continuously monitor their inventory
levels and more quickly replace missing items. Reflecting this trend, inventory to-sales
ratios recently have been declining in many industries. Thus, there appears to be less need
for traditional inventory financing and many businesses are experiencing lower inventory
financing costs. In the future, lenders will be forced to develop other services in order to
replace potential losses in inventory-loan revenues as new software-driven tech nology
speeds up ordering and shipment, allowing businesses to get by with leaner in-house stocks
of goods and raw materials.

Working Capital Loans

Key URL
If you want to learn
more about the
regulations applicable
to loans for small
businesses and for
minority groups
(including loans made
to minority-owned
businesses) where can
you go? See the
educational pamphlets
available at www.
federalreserve.gov.

Working capital loans provide businesses with short-run credit, lasting from a few days to

about one year. Working capital loans are most often used to fund the purchase of inventories
in order to put goods on shelves or to purchase raw materials; thus, they come closest to the
traditional self-liquidating loan described previously.
Frequently the working capital loan is designed to cover seasonal peaks in the business
customer's production levels and credit needs. For example, a clothing manufacturer antici pating heavy demand in the fall for back-to-school clothes and winter wear will require
short-term credit in the late spring and summer to purchase inventories of cloth and hire
additional workers. The manufacturer's lender can set up a line of credit stretching from six
to nine months, permitting that manufacturer to draw upon the credit line as needed over this
period. The amount of the credit line is determined from the manufacturer's esti mate of the
maximum amount of funds that will be needed at any point during the six to nine-month
term of the loan. Such loans are frequently renewed under the provision that the borrower
pay off all or a significant portion of the loan before renewal is granted.
Normally, working capital loans are secured by accounts receivable or by pledges of
inventory and carry a floating interest rate on the amounts actually borrowed against the
approved credit line. A commitment fee is charged on the unused portion of the credit line
and sometimes on the entire amount of funds made available. Compensating deposit
balances may be required from the customer. These include required deposits whose min imum size is based on the size of the credit line (e.g., 1 to 5 percent of the credit line) and
required deposits equal to a stipulated percentage of the total amount of credit actually
used by the customer (e.g., 15 to 20 percent of actual drawings against the line).

Interim Construction Financing

A popular form of secured short-term lending is the interim construction loan, used to support the construction of homes, apartments, office buildings, shopping centers, and other
permanent structures. Although the structures involved are permanent, the loans themselves
are temporary. They provide builders with funds needed to hire workers, rent or lease con struction equipment, purchase building materials, and develop land. But once the construction
phase is over, this short-term loan usually is paid off with a longer-term mortgage loan issued
by another lender, such as an insurance company or pension fund. In fact, many commercial
lenders will not lend money to a property developer until that customer has secured a mortgage
loan commitment to provide long-term financing of a project once its construction is
completed. Recently, some lenders have issued "minipermanent" loans, providing funding for
construction and the early operation of a project for as long as five to seven years.

596 Part Six Providing Loans to Businesses and Consumers

Security Dealer Financing

Key URLs

Dealers in

securities

Business loan officers need

short-term
have a big job today
financing to purchase
keeping up with
new securities and
changing trends in the
their existing
nature and technology carry
portfolios
of securities
of commercial credit.
The Web aids them in until they are sold to
this educational area customers
or reach
through such sites as
maturity.
Such
loans
those maintained by the
normally
are
readily
Risk Management
because of
Association (RMA) at granted
www.rmahq.org and
their high quality
Quick Start at
often
backed
by
www.quick-start.net .

pledging the dealer's

holdings of government securities as
collateral. Moreover, many loans to
securities dealers are so shortovernight
to a few daysthat the lender can quickly
recover its funds or make a new loan at a
higher interest rate if credit markets have
tightened up.
A related type of loan is extended to
investment banking firms to support their
underwriting of new corporate bonds,
stocks, and government debt. Such issues of
securities occur when investment bankers
help their business clients finance a merger,
assist in taking a company public so that its
ownership shares can be purchased by any
interested investor, or aid in launching a
completely new venture. Once the
investment banker is able to sell these new
securities, the loan plus interest owed is
repaid.
Banks and security firms also lend directly
to businesses and individuals buying stocks,
bonds, options, and other financial
instruments. Margin requirements enforced
in the United States by the Federal Reserve
Board usually limit such loans to no more
than half the amount of the security or
securities being acquired (under Regulation
U). However, in an effort to aid the market
for small business capital, the Fed ruled in
December 1997 that selected lenders could
loan up to 100 percent of the purchase price
of "small cap" stocks listed by NASDAQ.

Retailer and
Equipment

Financing
Business
lenders
support
installment
purchases of
automobiles
,
home
appliances,
furniture,
business
equipment,
and
other
durable
goods
by
financing
the
receivables
that dealers
selling these
goods take
on
when
they write
installment
contracts to
cover
customer
purchases.
In
turn,
these
contracts
are
reviewed by
lending
institutions
with whom
the dealers
have
established
credit
relationship
s. If they
meet
acceptable
credit
standards,
the
contracts
are
purchased
by lenders
at
an
interest rate
that varies

with the risk

level
of
each
borrower,
the quality
of collateral
pledged,
and the term
of
each
loan.
In
the
case
of
dealers
selling
automobiles
,
business
and
electronic
equipment,
furniture,
and
other
durable
goods,
lenders may
agree
to
finance the
dealer's
whole
inventory
through
floor
planning.
The lender
agrees
to
extend
credit to the
dealer so he
or she can
place
an
order with a
manufacture
r to ship
goods
for
resale.
Many such
loans are for
90-day
terms
initially and
may
be
renewed for
one or more
30-day

periods. In
return
for
the loan the
dealer signs
a
security
agreement,
giving the
lending
institution a
lien against
the goods in
the event of
nonpayment
. At the
same time
the
manufacture
r
is
authorized
to
ship
goods to the
dealer and
to bill the
lender
for
their value.
Periodically,
the lender
will send an
agent
to
check
the
goods
on
the dealer's
floor
to
determine
what
is
selling and
what
remains
unsold. As
goods
are
sold,
the
dealer sends
a check to
the lender
for
the
manufacture
r's invoice
amount,
known as a
"pay-assold"
agreement.
If
the

lender's
agent visits
the dealer
and
finds
any
items
sold off for
which
the
lender
___________________________has
not
received
payment
(known
as_"soldout
ofitrust"),_pa
yment will
be
requested_i
mmediately for
those
particular
items. If the
dealer fails
to pay, the
lender may
be forced to
repossess the
remaining
goods and
return some
or all of
them to the
manufacture
r for credit.
Floor
planning
agreements
typically
include
a
loan-loss
reserve, built
up from the
interest
earned
as
borrowers
repay their
loans, and is
reduced
if
any loans are
defaulted.
Once
the
loan-loss

reserve
reaches
a
predetermine
d level, the
dealer
receives
rebates for a
portion
of
the interest
earned
on
the
installment
contracts.

COMPETITION IN LENDING BETWEEN BANKS

AND CAPTIVE FINANCE COMPANIES
Among the most aggressive competitors of banks in
granting loans to businesses and individuals today are
finance companies. Between 1999 and the first
quarter of 2005 finance companies' total assets grew by
42 percent, just slightly more than U.S. banking's 41
percent asset growth over the same time period.
However, finance company loans to individuals soared
upward at more than twice the growth rate of consumer
credit in the banking sector.
Especially active were the "captive finance companies"
affiliated with large manufacturing companies. Among the
most visible "captives" are such familiar names as General
Motors Acceptance Corporation (GMAC), Ford Motor
Credit, and GE Capital, which, among other activities,
provide customer financing to promote the sales of their
manufacturing parents' products. Many of the captives
have become giant firmsfor example, GE Capital has
sufficient assets to rank it among the top 10 U.S. banks.
Why have these aggressive business and consumer
lenders been so successful in competing with bankers
in recent years?

Key URLs
The World Wide Web
provides some guidance
on analyzing and
granting different types
of business loans. For
example, there are sites
on lending to small
businesses at
www.sba.gov/7alenders/
and the ABCs of
Borrowing at www.
howtoadvice.com/
borrowing. To learn
more about asset-based
borrowing and
international lending see
especially
www.factors.net and
jolis.worldbankimflib.
org/external.htm.

Some experts point to the heavy burden of federal and

state regulation banks must carry that may retard their
growth. Others point to the fact that captives can
package together the purchasing and financing of their
parents' products, linking manufacturing and finance in
ways banks cannot do. Indeed, the United States has
erected a high wall separating banking from
manufacturing out of fear that allowing these two
industries to amalgamate could weaken the banking
system.
Moreover, captives are able to generate profits at
several different points in a typical customer transaction
by manipulating sales prices, terms of credit, and other
aspects of the customer-supplier relationship, possibly
masking some of the costs the customer ultimately pays.
And captives can more readily refurbish and resell any
products their customers turn back or cannot pay off.
While banks must sell the collateral they seize from bad
loans in the same markets as captives do, many bankers
are unable to complete that task efficiently and at low
cost. Captive finance companies have established a solid
foothold in the financial system and bankers must find
new ways to work competitively with these giant
financial firms.

Asset-Based Financing
An increasing portion of short-term lending in
recent years has consisted of asset-based
loanscredit secured by the shorter-term assets
of a firm that are expected to roll over into cash in
the future. Key business assets used for many of
these loans are accounts receivable and inventories.
The lender commits funds against a specific
percentage of the book value of outstanding credit
accounts or against inventory. For example, it may
be willing to loan an amount equal to 70 percent of
a firm's current accounts receivable (i.e., all those
credit accounts that are not past due). Alternatively,
it may make a loan for 40 percent of the business
customer's current inventory. As accounts receivable
are collected or inventory is sold, a portion of the
cash proceeds flow to the lending institution to
retire the loan.
In most loans collateralized by accounts
receivable and inventory, the borrower retains title
to the assets pledged, but sometimes title is passed
to the lender, who then assumes the risk that some
of those assets will not pay out as expected. The
most common example of this arrangement is

where the lender takes on the

responsibility of collecting on the accounts
receivable of one of its business customers.
Because the lender incurs both additional expense
and risk with a factored loan, it typically assesses a
higher discount rate and lends a smaller fraction of
the book value of the customer's accounts
receivable.
factoring,

Syndicated Loans (SNCs)

A syndicated loan normally consists of a loan
package extended to a corporation by a group of
lenders. These loans may be "drawn" by the
borrowing company, with the funds used to support
business operations or expansion, or "undrawn,"
serving as lines of credit to back a security issue or
other venture. Lenders engage in syndicated loans
both to reduce the heavy risk exposures of these
large loans, often involving millions or billions of

Key URL
If you would like to
learn more about
syndicated loans, see
especially www.federal
reserve.gov/releases/
snc/default.htm.

548 Part Six Providing Loans to Businesses and Consumers

dollars in credit for each loan, and to earn fee income (such as facility fees to open a credit "line or
commitment fees to keep a line of credit available for a period of time).
Many syndicated loans are traded in the secondary (resale) market and usually carry an
interest rate based upon the London Interbank Offered Rate (LIBOR) on Eurodollar
deposits. Syndicated loan rates in recent years have generally ranged from 100 to 400 basis
points over LIBOR, while the loans themselves usually have a light to medium credit qual ity grade and may be either short-term or long-term in maturity.
Because of the size and character of SNCs, federal examiners look at these loans care fully, searching for those that appear to be classified creditsthat is, weak loans that are
rated, in the best case, substandard, doubtful if somewhat weaker, or, in the worst case, an
outright loss that must be written off. Interestingly enough, the majority of classified SNCs
are held by nonbank lenders (such as finance and investment companies), which often take
on subinvestment-grade loans in the hope of scoring exceptional returns.

17-5 Long-Term Loans to Business Firms

Term Business Loans
Term loans are designed to fund longer-term business investments, such as the purchase of
equipment or the construction of physical facilities, covering a period longer than one year.
Usually the borrowing firm applies for a lump-sum loan based on the budgeted cost of its
proposed project and then pledges to repay the loan in a series of monthly or quar terly
installments.
Term loans usually look to the flow of future earnings of a business firm to amortize
and retire the credit. The schedule of installment payments is usually structured with the
borrower's normal cycle of cash inflows and outflows firmly in mind. For example, there
may be "blind spots" built into the repayment schedule, so no installment payments will be
due at those times when the customer is normally short of cash. Some term loan
agreements do not call for repayments of principal until the end of the loan period. For
example, in a "bullet loan" only interest is paid periodically, with the principal due when
the loan matures.
Term loans normally are secured by fixed assets (e.g., plant or equipment) owned by the
borrower and may carry either a fixed or a floating interest rate. That rate is normally higher
than on shorter-term business loans due to the lender's greater risk exposure from such
loans. The probability of default or other adverse changes in the borrower's position is
certain to be greater over the course of a long-term loan. For this reason, loan officers and
credit analysts pay attention to several different dimensions of a business customer's term
loan application: (1) qualifications of the borrowing firm's management, (2) the quality of
its accounting and auditing systems, (3) whether or not the customer conscien tiously files
periodic financial statements, (4) whether the customer is willing to agree not to pledge
assets to other creditors, (5) whether adequate insurance coverage will be secured, (6)
whether the customer is excessively exposed to the risk of changing technology, (7) the
length of time before a proposed project will generate positive cash flow, (8) trends in mar ket demand,and (9) the strength of the customer's net worth position.

Revolving Credit Financing

A revolving credit line allows a customer to borrow up to a prespecified limit, repay all
or a portion of the borrowing, and reborrow as necessary until the credit line matures.
One of the most flexible of all business loans, revolving credit is often granted without
specific collateral and may be short-term or cover a period as long as five years. This

OVERCOMING BARRIERS TO SMALL BUSINESS

LENDING:
THE
SMALL
BUSINESS
ADMINISTRATION AND CONSOLIDATING BANKS
Small business owners for generations have argued that
access to loans is one of the most challenging hurdles
they face. The credit markets seem to prefer the largest
borrowers, who usually command the best terms. Small
businesses (which number close to 25 million in the
United States alone) typically have fewer options for
fund raising and often pay dearly for the credit they do
obtain. This concerns public-policymakers because small
businesses create most of the new jobs in the economy.
This apparent size bias in the financial marketplace
led in the 1950s to creation of the Small Business
Administration to guarantee loans made to small
businesses by private lending institutions. Under the
SBA's popular 7(a) loan programs that agency
guarantees repayment of small business loans up to a
maximum of $1 million. (The largest loan currently
allowed under the program is $2 million.) SBA provides
credit
to
nearly
75,000
applicants
annually.
Unfortunately for small businesses, however, the SBA
recently tightened its credit rules and raised fees on its
guarantees.

If thatwasn't bad news enough, research evidence

suggests that consolidation of the banking system maybe
resulting in a decline in the proportion of all loans devoted
to small business. Commercial banks make more business
loans than any other financial firm; however, banks
pursuing merger strategies seem to grow their small
business loans more slowly than nonmerging institutions.
Moreover, the largest banks don't seem to know their small
business customers as well as smaller lenders do. This may
suggest the small business sector could run into a "credit
crunch" in the future if the banking sector continues to
march toward bigger banks.
However, some experts suggest there may notbe a
developing problem here. While the percentage of bank
loan portfolios devoted to small businesses may be falling
the total amount of credit supplied to small firms may
actually be rising. For example, if a bank's loan portfolio
grows from $100 million to $200 million and the
percentage of its portfolio devoted to small business
lending falls from 10 percent to 8 percent, the total
amount of small business credit actually risesfrom $10
million (or 0.10 x $100 million) to $16 million (or $200
million x 0.08). Thus, the jury is still out on whether small
business lending is likely to expand or decline as the
banking system consolidates further into giant firms.

form of business financing is particularly popular

when the customer is highly uncertain about the
timing of future cash flows or about the magnitude of
his or her future borrowing needs. Revolving credit
helps even out fluctuations in the business cycle for a
firm, allowing it to borrow extra cash when sales are
down and to repay during boom periods when
internally generated cash is more abundant. Lenders
normally will charge a loan commitment fee either on
the unused portion of the credit line or, sometimes, on
the entire amount of revolving credit available for
customer use.
Loan commitments are usually of two types. The
most common is a formal loan commitment, which is a
contractual promise to lend up to a maximum amount of
money at a set interest rate or rate markup over the
prevailing base rate (prime or LIBOR). In this case, the
lender can renege on its promise to lend only if there
has been a "material adverse change" in the borrower's
financial condition or if the borrower has not fulfilled
some provision of the commitment contract. A second,
looser form is a confirmed credit line, where the
lending institution indicates its approval of a customer's

request for credit, though the price of such a credit line

may not be set in advance and the customer may have
little intention to draw upon the credit line, using it
instead as a guarantee to back up a loan obtained
elsewhere. These looser commitments typically go only
to top-credit-rated firms and are usually priced much
lower than formal loan commitments.
One form of revolving credit that has grown rapidly in
recent years is the use of business credit cards. Many
small businesses today have come to depend upon credit
cards as a source of operating capital, thus avoiding
having to get approval for every loan request.
Increasingly popular is credit-card receivables financing
in which merchants receive cash advances and pay them
off from their credit-card sales. Unfortunately, the interest
rates charged usually are high and if a personal card is
used, the business borrower winds up being personally
liable for the business's debts.

550 Part Six Providing Loans to Businesses and Consumers

Long-Term Project Loans

The most risky of all business loans are project loanscredit to finance the construction
of fixed assets designed to generate a flow of revenue in future periods. Prominent exam ples include oil refineries, power plants, and harbor facilities. The risks surrounding such
projects are large and numerous: (1) large amounts of funds, often several billion dollars'
worth, are involved; (2) the project may be delayed by weather or shortage of materials;
(3) laws and regulations in the region where the project lies may change in a way that
adversely affects project completion or cost; and (4) interest rates may change, adversely
affecting the lender's return on the loan or the ability of the project's sponsors to repay.
Project loans are usually granted to several companies jointly sponsoring a large project.
Due to their size and risk, project financings are often shared by several lenders.
Project loans may be granted on a recourse basis, in which the lender can recover funds
from the sponsoring companies if the project does not pay out as planned. At the other
extreme, the loan may be extended on a nonrecourse basis, in which there are no sponsor
guarantees; the project stands or falls on its own merits. In this case, the lender faces sig nificant risks and, typically, demands a high contract loan rate. Many such loans require
that the project's sponsors pledge enough of their own capital to help see the project
through to completion.
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Loans to Support the Acquisition of Other Business Firms

The 1980s and 1990s ushered in an explosion of loans to finance mergers and acquisitions of
businesses before these loans slowed as the 21st century opened. Among the most noteworthy
of these acquisition credits are LBOsleveraged buyouts of firms by small groups of
investors, often led by managers inside the firm who believe their firm is undervalued in the
marketplace. A targeted company's stock price could be driven higher, it is argued, if its new
owners can bring more aggressive management techniques to bear, including selling off some
assets in order to generate more revenue.
These insider purchases have often been carried out by highly optimistic groups of
investors, willing to borrow heavily (often 90 percent or more of the LBOs are financed by
debt) in the belief that revenues can be raised higher than debt-service costs. Frequently the
optimistic assumptions behind LBOs have turned out to be wrong and many of these loans
have turned delinquent when economic conditions faltered.

17-6 Analyzing Business LoanApplications

In many business loan situations the lender's margin for error is narrow. Often business loans
are of such large denomination that the lending institution itself may be at risk if the loan goes
bad. Moreover, competition for the best business customers tends to reduce the spread between
the yield on such loans and the cost of funds that the lender must pay in order to make these
loans. For most business credits, lenders must commit roughly S100 in loanable funds for each
$1 earned after all costs, including taxes. This is a modest reward-to-risk ratio, which means
that business lenders need to take special care, particularly with loans of large