Inspect What You Expect

This month’s blog is the second of a three-part series on what an effective credit management program might look like. Last month we looked at different organizational structures. This month we are focusing on the importance of having an effective tracking and monitoring program. We will wrap up the series next month with a discussion on documentation of approved credit arrangements.

It appears we are totally consumed with monitoring all aspects of our life. We purchase watches that count our steps and track where we travel. We monitor our blood pressure and track our heart rate. We measure how fast we run and how high we jump. Not only do we monitor ourselves, but our cars monitor everything from tire pressure, to oil life, to cross traffic, and even distance to vehicles ahead. For those with extraordinary resources and a love for technology, you can even get an autonomous driving vehicle. (Yikes!)

Given our preoccupation with monitoring so many things in our daily lives, and the tendency for people in the commercial banking profession to be pretty obsessive in general, it would seem that we would be equally compulsive in monitoring our lending relationships. While a few commercial loan accommodations do fall into the “find it, fund it, forget it” category (which dominates consumer lending, where your “monitoring” is timely payment), we are either cavalier about the type or frequency of reporting we require of our borrowers, or we don’t invest the time, effort or resources into a reliable tracking system.

The first step in a good relationship management program is to determine what the key performance elements or risks are in any given relationship. Is it profitability? Cash flow? Leverage? Collateral position? It may be a good start to require annual tax returns or financial statements on your borrower and/or guarantor, but it is equally important to establish the parameters for when these documents should be submitted. In the case of business financial statements, loan documents should specify the frequency (monthly, quarterly or annually) and when they need to be provided (for example, 30 days after period end for interims, and 120 days for annual statements). Since we don’t want to collect information just to fill file drawers or check boxes, loan documents should include performance covenants as the “guard rails” for the relationship. This might be a simple net worth covenant for a real estate holding company or small business, or a more sophisticated program of performance covenants including debt service coverage, debt to worth, current ratio, etc. for a more complex operating company.

Financial performance parameters may also be supplemented with collateral tracking. Collateral tracking requirements could involve monthly or quarterly submission of accounts receivable, inventory and/or accounts payable reports. When combined with formula reporting on current assets (accounts receivable and inventory), the lending institution has a powerful tool for monitoring the use of loan proceeds as well as collateral position.

Probably the most difficult piece of any credit management system is the actual tracking of the required reporting elements. As an industry, we are pretty darn good at tracking payment receipt. Tracking financial and collateral reporting requirements? Not so much. Part of this is a system issue. Do we have a system with the capacity to handle all the required data elements? Do we have people to maintain the system? A second issue is process. Is there a process in place that clearly establishes who is responsible for receipt of information and data input? The best system cannot make up for poor process and accountability. The adage “garbage in equals garbage out” certainly is true in credit management systems. The prior blog discussed different organizational structures for credit management. Regardless of the organizational structure, clearly defined responsibilities are critical.

One of the worst results of a system or process failure is that the credit and lending staff lose confidence in the information generated. Since the entire point of a tracking system is to follow-up with the borrower in instances of non-compliance or covenant default, system credibility is essential. And follow-up is not just restricted to follow-up with the borrower. Based upon experience in numerous loan review engagements, given the amount of missing and/or delinquent financial reporting, it seems that internal management is not prioritizing timely follow-up with the credit and lending staff.

As experienced credit and lending professionals, we all know that the sooner we become aware of a problem, the easier it is to fix or, if not fixable, the smaller the financial loss. We also know that clear communication is essential to a healthy credit relationship. One of the best ways of developing a solid banking relationship is by discussing and establishing expectations with the borrower. The best way to monitor if the relationship is going as planned and expected is to “inspect” through a quality tracking system.

Or as Ronald Reagan said: “Trust but verify.”

Richard Rudolph is Senior Consultant at Enlighten Financial, a specialized consulting firm that focuses on loan review and risk management services to community banks and credit unions. Enlighten Financial has made it our business to shed light on the complex financial landscape, and lead clients in the right direction. We work with financial institutions and other providers to mitigate risk. To talk to Rick directly, please call: 920.264.9150.