March 2, 2009
You cannot turn on the television or read the newspaper today without hearing more news about banks tightening their credit standards during these challenging economic times.
One can argue that Rochester has faired far better than other parts of our country in the current downturn, but there remains much discussion about lenders exiting markets or changing underwriting standards. As such, I thought it would be a good idea to provide a lender’s perspective on the evaluation of potential commercial borrowers.
All bankers should be intimately familiar with the five Cs of credit - character, capacity, capital, collateral and conditions. When the economy is strong and credit is abundant, some lenders may overlook those fundamental principles of lending. (Think of the liberal underwriting standards used by many non-bank lenders over the past few years - many of which no longer exist.)
When the economic pendulum swings the other way - as it always does - banks often return to the fundamentals.
First and foremost, know the borrower. A borrower’s reputation, repayment history and their experience in business tend to be weighed during the evaluation process.
Generally, the evaluation is a subjective one, and two lenders might arrive at different conclusions. At CNB, as is the case at many other community banks, our initial due diligence process is extensive. It is through such a process that we get to know the borrower, their history, their management team and their performance expectations for the future.
Although it can seem laborious at first, the benefits become evident during downturns in the borrower’s business cycle. A borrower should never have to ask, "Does my lender really know me and understand my business?"
Is cash flow from operations sufficient to repay the loan request?
There are many ways in which lenders can evaluate cash flow, ranging from the simple traditional cash flow approach to the more advanced Uniform Credit Analysis (UCA) approach. The traditional approach examines the profit and loss statement; the UCA approach also considers changes in a company’s balance sheet, along with the impact of those changes on cash flow. Specialized, industry-specific measures of cash flow also may be used, such as the "contractor cash flow." Each method has its own strengths and weaknesses, but all provide an indication of a borrower’s ability to repay.
Other questions include: Does the loan request rely on projected cash flow, or is historical cash flow sufficient? Does a guarantor’s personal cash flow need to be considered to offset deficit business cash flow?
Such scenarios should be considered when evaluating a loan request.
Lenders typically limit exposure in a transaction by requiring a borrower to contribute meaningful equity.
The measure, which should be transaction-specific, ensures the business has a commitment to the deal. Lenders also evaluate the strength of a company’s balance sheet by comparing total debt to total equity - a good indicator of risk that should be compared to the industry average, since different industries tend to exhibit different leverage ratios. The figure also should be examined over time, since trends may be revealed. Lenders enjoy seeing low leverage ratios, which exemplify a greater ability to withstand swings in a business cycle.
Banks typically require collateral to secure a loan. If a borrower defaults, the lender can take possession of the collateral.
The term of a loan should be matched with the estimated useful life of the underlying collateral. We can all agree, for instance, that it would not be prudent to amortize an auto loan over 20 years.
Unsecured loans -or loans that do not require collateral - typically are granted on a short-term, case-by-case basis to high net worth individuals.
Many other variables can affect a loan’s approval. They may be specific to the borrower, such as the size of the loan facility, or they may be specific to the bank, such as industry concentrations within the institution’s portfolio of loans.
Without question, the current economic outlook - from industry, local and national perspectives - plays a great role in the decision-making process. A volatile or unstable economic outlook can impact an evaluation negatively; however, a positive outlook can increase the likelihood of obtaining the loan.
Banks also use covenants in a lending relationship to maintain loan quality and mitigate risks.
The current economic downturn will be challenging, and the "blame game" could continue forever, but I believe the downturn can be attributed partially to a lapse of the fundamental principles of lending.
Does anyone really know the borrower when commercial mortgages are securitized? How can lenders truly evaluate cash flow or capacity with a stated income "no-doc" loan?
Lenders that remained true to the Five Cs also weathered the storm in 2008. While other financial institutions are contracting, Canandaigua National Bank & Trust and many other community banks are working to ensure Main Street receives the financing it needs.
Brendon Crossing, Vice President, Commercial Banking, can be reached at email@example.com or by phone at (585) 419-0670 ext. 50638.