Credit Underwriting Gets Grilled
Fall brings back so many of the things we love: kids going back to school, the return of regular schedules and, of course, football season. It’s also a great time to throw some burgers on the grill and enjoy the last few days of nice weather before many of us head inside for winter.
While grilling a meal with family and friends can be a great time, having your credit underwriting and analysis grilled by examiners is most likely not.
In 1996, the Comptroller of the Currency raised concerns regarding a trend of easing commercial underwriting standards. The concern was that changes in loan underwriting standards may have unintended effects on the risk parameters of loan portfolios that may be amplified with changes in the economy. We are hearing similar concerns from the regulatory agencies today regarding the easing of credit standards in the headwinds of fierce competition for a limited supply of deals.
The OCC issued Advisory Letter 97-3 (AL) in 1997 to highlight the major elements of an effective portfolio credit risk management process in response to what was perceived as an easing of credit standards. At the time, banks were managing an abundance of liquidity and competition in the market, and there was continued consolidation in the banking industry. Regulators were fearful bank management was moving away from the discipline of a long-term strategic portfolio approach to satisfy the pressure for growth and earnings. Sound familiar?
Examiners are expecting financial institutions to perform credit underwriting at a level commensurate with the complexity of the loan opportunity. Three key things typically form the foundation for a successful underwriting package: cash flow on the primary source of repayment, analysis of the collateral pledged to the loan, and review of global cash flow. Additional factors should also be considered depending on the opportunity, including:
- Borrower trends: How is the borrower performing over a period of time, rather than simply the current year under review? A cash flow that is growing tighter could be an indication that the borrower is not passing price increases on to their customer or controlling expenses.
- Balance sheet performance: A strong and strengthening balance sheet provides the borrower some flexibility if tough times are ahead. A balance sheet with minimal liquidity and equity could signal trouble if the income statement is negatively impacted.
- Stress testing: Understanding how the borrower performs in various stressed situations can provide further detail on the overall risk profile of the borrower. Testing for changing interest rates is a common approach, but stress testing can also help understand changing margins, rental rates, tenant mix and more.
- Tenant mix and strength: The performance of commercial real estate is directly related to the strength of the tenants. Understanding the quality of tenant and terms of the lease are important factors to fully understanding the likelihood that the property will continue to perform.
- Commodity markets: Changes in commodity prices are key factors in determining if agricultural credits will improve or face additional hardship.
- Budgets: In certain cases, your borrower should be providing a budget for anticipated financial performance. Not only can this help the financial institution, but this also helps to ensure the borrower is planning and looking ahead to credit or operational needs before they arise.
- Guarantor strength: Guarantors are often the third source of repayment for commercial loans, after operations of the business and liquidation of collateral. Verifying liquidity and understanding contingent liabilities can provide support to the strength of the loan relationship.
The appropriate level of credit underwriting is one of the most important factors in determining the overall risk profile of a borrower. Examiners are paying attention and making sure financial institutions are completing a well-rounded analysis.
Peter Nugent is Director and founder of Enlighten Financial, a specialized consulting firm that focuses on providing loan review and risk management services to community banks and credit unions. Peter guides the company’s service offerings, which include in-depth loan reviews, commercial and personal underwriting/analysis, internal process improvement and workout services. To talk to Peter directly, please call: (920) 354-6797.