1. Regulatory Limitation
Regulation limits a national bank's total outstanding loans and extensions of credit to one borrower to 15% of the bank's capital and surplus, plus an additional 10% of the bank's capital and surplus, if the amount that exceeds the bank's 15 percent general limit is fully secured by readily marketable collateral. In simple terms a bank may not lend more than 25% of its capital to one borrower. Different banks have their own in-house limiting policies that do not exceed 25% limit set by the regulators.
The other limitations are credit type related. These too differ from bank to bank. For example:
2. Lending Criteria (Lending Policy)
This too can be categorized into product and credit limitations as discussed below:
• Product Limitation
Banks have their own internal credit policies that outline inner lending limits per loan type depending on a bank's appetite to book such an asset during a particular period. A bank may prefer to keep its portfolio within set limits say, real estate mortgages 50%; real estate construction 20%; term loans 15%; working capital 15%. Once a limit in a certain class of a product reaches its maximum, there will be no further lending of that particular loan without Board approval.
• Credit Limitations
Lenders use various lending tools to determine loan limits. These tools may be used singly or as a combination of more than two. Some of the tools are discussed below.
Leverage
If a borrower's leverage or debt to equity ratio exceeds certain limits as set out a bank's loan policy, the bank would be reluctant to lend. Whenever an entity's balance sheet total debt exceeds its equity base, the balance sheet is said to be leveraged. For example, if an entity has $20M in total debt and $40M in equity, it has a debt to equity ratio or leverage of 1 to 0.5 ($20M/$40M). This is an indicator of the extent to which an entity relies on debt financing. Banks set individual upper in-house limits on debt to equity ratios, usually 3:1 with no more than a third of the debt in long term
Cash Flow
A company can be profitable but cash strapped. Cash flow is the engine oil of a business. A company that does not collect its receivables timely, or carries a long and perhaps obsolescence inventory could easily shut own. This is known as cash conversion cycle management. The cash conversion cycle measures the duration of time each input dollar is tied up in the production and sales process before it is converted into cash. The three working capital components that make the cycle are accounts receivable, inventory and accounts payable.
Cash conversion cycle = accounts receivable + inventory - accounts payable
Debt Service Coverage Ratio (DSCR)
Banks pay special interest on the ability of a borrower to service principal and interest payments. After all they are in the business lending money at a return (interest). Normally banks require a debt service coverage ratio of 1.20 minimum. In simple terms that means if you borrow $100, your debt service coverage ratio should be at least $120. This ratio will also determine the level of debt a borrower can carry.
Repayment Source
A repayment source can also limit the amount of money that could be borrowed. For example, if the source of repayment is rental income from a property that has a history of large vacancies, a bank may discount the expected rental income heavily, thus limiting the amounts that could be borrowed.
Collateral
While in theory many lenders say that collateral is the last criteria they consider when analyzing a loan request, in practice however, collateral ranks number one. Lenders measure collateral adequacy by a ratio known as loan to value (LTV). Loan to value ratio of 80% is considered satisfactory. This means that if your collateral is valued for $100, you are eligible to borrow a maximum of $80, all being equal. The quality of collateral plays a major role in deciding on the discounting factor of a collateral. For example, discounting factor of real estate is lower than of receivables or inventory.
Other lending criteria
A lender concerned by the experience of the management may reduce the loan request in order to minimize risk. Other risks such as industry, business, and political may influence a lender's decision in determining the amount to be lent.
