Part 1: Know Your Customer, Know Your Culture
The practice of commercial credit risk management is both an art and a science. Recent technological developments have dramatically enhanced the daily processes associated with this field, but significant room still exists for experiential nuance when evaluating business relationships and managing outstanding facilities.
“The more things change, the more they stay the same.” Jean-Baptiste Alphonse Karr
The basic flow of business has not changed as it relates to analyzing income statements, balance sheets, cash flows, and debt service coverage. At the same time, new challenges present themselves to small business owners every day. The competitive environment moves much more quickly than it did twenty years ago – for both the lender and the borrower. Both have used technology to address the changing speed of business. The following text outlines the key factors associated with successful management of commercial credit portfolios today as it relates to basic time-tested business rules living alongside dramatic changes in process and workflow.
Truth #1. Credit Management Always Begins at the Time of Initial Underwriting (Vision, Acumen, and Structure)
Understanding the business owner’s vision for the company is critical to making an initial credit decision. As a lender, if you cannot buy into that vision, do yourself a favor and walk away. Not every borrower-lender match is made in heaven, and sometimes a request is just not the right fit for the two parties. For new business clients, the underwriting phase is the time to begin developing a relationship. This involves much more than simply reviewing financials and business plans. It goes beyond ratio analysis and write-ups. If your goal is to develop a long-term business relationship with multiple loan requests over the coming years, take this time to really understand the owner’s vision for their company.
In addition to understanding the overall vision, this is also a time to assess the business acumen of your applicant. Have they grown up in the industry? Do they know their way around a financial statement? Have they surrounded themselves with a support team such as a good CPA and business attorney? Does their financial forecast make sense? These questions will help you evaluate whether the owner understands the general dynamics of the business, from sales and marketing to income, expenses and human recourse allocations. As lenders we have all seen business owners who are extremely creative and entrepreneurial. That alone is not enough to ensure success. The bigger question is how do the owner’s talents match up with the rest of the management team they have assembled?
Lastly, remember that credit quality begins with deal structure. Make sure your proposal matches the applicant’s business needs. Make sure your new client understands the terms of your loan agreement. Think back over the loans you have closed during your career. How much time did you spend discussing deal structure, loan covenants and terms with your client? How many of your clients read the Note and Security Agreement? Strong debtor, creditor relationships rely on effective communication and boundaries. Take the time to educate the business owner on the structure of your proposal. After all, in many cases, your financial institution has more money at risk than the business owner has invested personally in the venture. Also, don’t be afraid to propose a product or structure that is different from the original loan requests. We have all seen businesses ask for one type of financing, only to realize that it would not meet their long-term needs.
Truth #2. Understanding Your Financial Institution’s Culture is Paramount to Your Success as a Credit Officer
Credit decisions are not made based on your personal view of risk versus reward, but on the risk appetite of the institution you serve. Sometimes, you will need to pass on what you believe to be a sound credit risk simply because it does not fit within the parameters of your organizations credit culture. Credit policies serve as the roadmap. Once new lenders in your organization learn the credit policy, they will begin to identify with the lending goals and preferences of your senior management team. Lender education is critical to this effort. In addition to making sure that your credit staff is trained to excel at underwriting, documentation and monitoring of portfolio assets, make sure they have an opportunity to spend time with your management team. This will help them to realize they are critical link between you and your client base.
Truth #3. Technology May Streamline the Process, But Human Action or Inaction Drives Credit Losses
Remember the seven deadly sins of credit management – denial of an issue, delay in taking action, allowing default, adding new debt to old troubled debt, gaps in documentation, divided opinions among the team, and guarantor dependence. The use of technology such as credit risk dashboards can greatly enhance lender experience and efficiency in this area. It can also give regulators what they seek the most, consistent credit risk management processes across individual lenders in an organization. While discussed in detail in a recent blog post, the seven deadly sins involve lenders falling into traps such as a false sense of security when managing their portfolios. They may sit on technical defaults, not realizing that they are a symptom of deeper issues with the condition of a borrower. They may delay action, thus increasing the chance that your organization will take a financial loss.
Be sure to utilize effective portfolio management systems to evaluate exceptions, collateral values, and other key data that points to overall credit health. These systems allow for both management oversight and consistency. More importantly, they put all your lenders on the same page by enforcing that each issue is addressed in a similar fashion. This gives you the consistency needed to manage overall credit risk.