Explanation:
D is the correct answer. Extending credit lines to small businesses based primarily on the owner's personal credit history is a significant red flag in the credit approval process. A business's ability to repay a loan depends on its own cash flows, business model, and overall financial health. While the owner's personal credit can provide some context, it does not substitute for a rigorous analysis of the business's repayment capacity, thereby exposing the bank to undue credit risk.
A is incorrect because granting a small consumer loan to a borrower with a stable income is a standard, low-risk lending practice.
B is incorrect because while relying heavily on collateral does not replace the need to assess the borrower's ability to repay, auto loans are secured by the vehicle. Depending on the underwriting standards, this is a common practice, whereas ignoring business fundamentals in commercial lending (as in option D) is a more glaring procedural deficiency.
C is incorrect because requiring a 20% down payment is a conservative, risk-mitigating approach in mortgage lending, ensuring the borrower has significant equity in the property and reducing the bank's loss given default (LGD).
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Q.5949 A credit risk committee at a community bank is reviewing its loan approval processes to better manage risks. The committee is particularly concerned about ensuring that the bank's lending practices are not exposing it to undue risk. Which of the following scenarios should raise a red flag for the committee as a potential risk factor in their credit approval process?
A
A borrower with a stable but modest income is granted a small consumer loan at a standard interest rate.
B
The bank routinely approves auto loans for borrowers with varied credit histories, relying heavily on the value of the vehicle as collateral.
C
For mortgage lending, the bank strictly adheres to a policy of requiring a 20% down payment from all borrowers.
D
The bank has a policy of extending credit lines to small businesses based primarily on the owner's personal credit history.
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