Shadow Banking

Part B

Analyse the article, Yakola, D. (2014) “Ten tips for leading companies out of crisis” Compare this article with Morgenson, G. (1999) “When a rosy picture should raise a red flag” Focus on the issues related to banks’ lending and restructuring prospects.

Quantitative

- Throw away your perceptions of a company in distress

- Force yourself to criticize your own plan

- Expect more from your board

- Focus on cash

- Create a great change story

- Treat every turnaround like a crisis

- Build traction for a change with quick wins

- Throw out your old incentive plans

- Replace a top-team member or two

- Find and retain talented people

Qualitative

-- Balance-Sheet Disparities

-- Unsustainable Sales

-- Reserves to the rescue?

-- Deferred Expenses

-- Acquired Profits

-- Inventory & Receivables

-- Watching write-offs

-- Core cutbacks

Since modern day banking evolution, banks have been constantly revising their lending policies to maintain a low defaulting borrower’s ratio. It is no doubt that their main priority is always to lend out profitable loan with a regular repayment and the lowest default probability. Thus, it leads to different approach that is taken to access if borrowers are worthy to receive credit as per requested.

Bank makes a wide variety type of loan to a variety of customers for many different type of purposes. Which included not limited to, real estate loans, financial institution loans, agricultural loans, commercial and industrial loans, loans to individuals, miscellaneous loans and lastly lease financing receivables. Real estate loans usually backup by real property, such as land, buildings, and includes short-term loans for construction and land development and longer-term loans to finance the purchase of farmland, homes, commercial structures and foreign properties. Financial institution loans comprise of credit to banks, insurance companies, finance companies and other financial institutions. Agricultural loans are stretch out to farms and ranches to assist in planting and harvesting crops and supporting the feeding and care of livestock. Commercial and industrial loans are allocated to business to cover purchasing inventories, paying taxes, and meeting payroll. Loans to individuals are a big part of retails loans. Where bank grant credits to finance the purchasee of automobiles, appliances and other retail goods, to repair and modernize homes (renovation loan) and to cover the cost of medical care and other personal expenses, and are either extended directly to individuals or indirectly through retail dealers (credit card purchases repaying monthly). A miscellaneous loan consists of loans that are not mentioned. (Securities’ loans). Lease financing receivables, where the bank buys equipment or vehicles and leases them to its customers. While bank receive interest and such loans are secured by equipment or vehicle as bank owns the full ownership of it.

Quantitative and Qualitative

Yakola, D. (2014) article, focus on quantitative aspects when assisting companies out of crisis that coincide with bank’s judgmental decision on evaluating a loan. Judgemental credit analysis is relying on consumer loan officer’s experience and insight when appraising borrower’s ability and willingness to repay. An intangible aspect which Yakola, D brought up was to expect more from your board. He mentioned it’s the board’s role to act as an early-warning system when a company is heading for distress, also to guide the CEO, CFO and COO from a distance with a proper overview of the situation in the right direction. It embedded the idea that a bank should look into the competency of the board of directors behind the company when evaluating a loan.

Yakola, D also mentioned the importance of cash. Many times the management team and board are so engrossed on complex metrics related to the earnings before interest and taxes (EBIT) and return on investment that exclude major uses of cash. Theoretically it is not wrong, but variations on EBIT commonly exclude depreciation, amortization, rents and fuel. These ignore the important usage of cash.  A failure to keep an eye on cash component of capital investments eventually gets companies in trouble. That will include making repayment to bank.

Encouraging changes in human asset might just do more good than harm. Yakola, D made a valid point that top-team members at times are incapable of shift in the mind-set needed to make fundamental changes to the operating philosophy they have believed in for years. They inevitably block that change because they are bent on defending what they believe to be true. It is of the utmost importance that what companies seek for and comprises of members that have leadership and institutional knowledge. Not necessarily do they have to be top performers, but they also have to know the company thoroughly which are vital to understand the impact of potential changes on the business. The bank must correctly read such interpretation of the company in order to ensure the expected return of the bank to be secured.

Morgenson, G. (1999) article focuses on qualitative aspects that mask performance of companies that is in line with bank’s empirical evaluation method when accessing a loan. Morgenson, G pointed out that there are times whereby there are differences between earnings reported to shareholders and those reported to the Internal Revenue Service (I.R.S.). Companies carry two sets of accounting books, which includes one for shareholders and the other for the I.R.S. A company might report higher earnings to shareholders through the use of deferred taxes. It works like deferred expenses such as Company deferring large amount of current expenses to later periods. For such intentions are to be scrutinized by bank in order to achieve an ethical and legitimate figure when making an evaluation for borrower’s credit request.

Through the use of empirical evaluation method, credit scores of borrowers are determined by using scoring models. Linear probability model, which uses past data such as accounting ratios, divide loans that have defaulted to non-default. “Logit” models which assume probability of default to be logistically distributed. Probit model assumes probability of default to be normally distributed. Discriminant model which separate borrowers into different default classes.

Creative accounting is the manipulation of financial numbers, usually is not against the law and certainly not providing the true and fair view of the company that accounts are supposed to, and resorted to show a rosy picture of the company or to conceal an unfavourable financial position. Some examples of the article like earning and cash flows, balance sheet disparity which link to internal and taxation purposes and core business cutbacks which is reducing research and development, maintenance expenses.