Most of us have heard of the seven deadly sins, but did you know there are also seven potentially damaging actions or inactions that can lead to credit loss? Lenders of all types should consider this list throughout every stage of the loan cycle and for all types of credit. These sins can show up at any time. While in some cases they are the primary cause of a credit loss, they are more likely what causes a loss to be greater than it otherwise would have been had the situation been handled differently. As you begin the new year, consider an open discussion with your consumer and commercial lending staff to ensure no one commits the seven deadly sins of credit management.
Special Note: As we enter 2020, there is an increasing likelihood that the US could enter a recession. Trade tensions in our country along with international economic challenges such as Brexit could have a significant impact on US businesses this year and next. We have already been experiencing a period of slower economic growth in many industry sectors. With that in mind, we have chosen to refresh and re-release this Seven Deadly Sins article, the first version of which was published in 2017.#1: Denial
No one wants to believe that a credit they are managing may be heading south. This is especially true if they initiated the credit. It is important to realize up front that while no one intentionally makes a bad loan, circumstances are always changing and loans do go bad from time to time. There may be a temptation to sweep a problem under the rug for a while, but early recognition of issues can often be the difference between small losses and large ones. If you see something that does not look or feel right with a particular credit, speak out early. Communication with your team and with the borrower can make a huge difference.
Denial often leads to the sin of delay. In sales, they say that time kills deals. In credit, time increases losses. The earlier you can recognize and initiate a strategy, the less likely you are to experience a significant loss within your institution. In some cases, you might be able to avoid a loss altogether and even help the borrower to recover and continue. In recent months, we have seen financial institutions go one step further by actively trying to monitor the financial health of their commercial clients through third party vendors that provide such services. Given how far we are into the current economic cycle, this strategy will likely pay dividends in the months ahead.#3: Default
Covenants, warranties, and default provisions exists for a reason. Yet, how many times have you seen lenders allow technical default to occur within a lending relationship? This muddies the water downstream, where such an allowance can cause significant heartache for anyone trying to work out of a bad credit. The core issue is that you established a boundary, and then allowed your borrower to run through it unchecked. The question becomes, where is the new boundary? When default occurs, take action to treat it. It is likely a symptom of a larger issue, and it may be possible to resolve it. The worst thing you can do is sweep it under the rug.#4: Debt
While managing a workout or stressed obligation, one of the toughest decisions to make is whether to put more money into a scenario. This typically applies to commercial loan types, but can also show up with consumer lending. The question here is whether the additional loan can help to alleviate the core issue and resolve the situation. When considering such a choice, ask yourself whether the new money is truly treating the issue, or just helping to manage a symptom. For the latter, new loans typically just add to the eventual credit loss.#5: Documentation
One of the first actions that should be taken during the early stages of a workout is a thorough review of documentation. Failure to initiate this step is number five on our list of deadly sins. During this early stage, it is much more likely that lenders and borrowers are having healthy conversations regarding a path forward. If you discover any holes in your documentation during a review, this is the best time to correct them. Should the situation deteriorate later, borrower cooperation will likely diminish.#6: Division
When managing through a workout, it is critical that everyone in your organization present a unified front. Any disagreements regarding the workout strategy or the path forward should be dealt with internally and you should achieve buy-in on the plan. This is why so many organizations move workouts to a centralized special assets or criticized asset area. Allowing a lender who is not emotionally connected to a loan to work through the process is more advisable.#7: Dependence
This refers primarily to guarantor dependence. Many of these loans never should have been booked in the first place. Guarantor dependence implies that the borrower, whether a consumer or a business, would not have passed your institution’s credit criteria on their own. Loans like that should be limited within your portfolio. When working out of such situations, you are injecting a third party of influence, the guarantor, into every conversation, which can increase the complexity of a workout. In worst case scenarios, you not only lose the future business or your borrower, but also the guarantor.
Additionally, if the loan is guarantor dependent, the lender should gain a clear understanding of other obligations also guaranteed by the ‘stronger party’. If the guarantee is stretched too thin or is tied to separate but similar credits (think multiple real estate loans at multiple institutions), then does the guarantee really support the credit being evaluated, or is it diluted?
So, there you have it: the seven deadly sins of credit management. Maybe you’ve seen some of these during your lending career already. If not, I hope you’ll recognize them now when they show up. When you do, just remember this…Communication is the best defense against the deadly sins. This includes communication between you and your borrower as well as internal communication between lending functions in your organization. Never be afraid to raise a flag early. It may save your institution thousands in legal fees and workouts.
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