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Your Bank > Education and Advice > CNB University

How Banks Limit Risk in Commercial Lending

J Nieman
JoAnn N. Mills is Vice President and can be reached at JNieman@CNBank.com or (585)419-0670 x50639.

We all understand the basic concept that one must take a certain amount of risk in order to receive a return. When lending money, risk is the chance you take that you might not be repaid either in full or in part. Since Commercial Banks are currently only realizing returns in the single digits for conventional loans, the Bank must also try to keep the level of risk it takes appropriate to this level of return. Unlike venture capitalist and private financing sources, the Bank does not have any “upside” potential on its lending investment other than collecting interest at the agreed upon interest rate. Unfortunately, the full “downside” potential exists that the funds lent out may not be repaid as well as the potentially significant expenses associated with collection of the debt. This is also why venture capitalists and private financing sources typically get much higher rates of interest than Banks do – they take on a higher level of risk.

So, how do Banks manage their lending risk? The first step is to identify the risk factors associated with each loan transaction. The primary means that Banks have to identify the risk is by knowing their Customers, applying the traditional underwriting criteria known as the “Five Cs of Credit” to the transaction and understanding their markets. Although these may seem obvious, the history of Banking is rife with tales of Bankers ignoring these basic steps and jumping into a transaction without fully analyzing and managing the “downside” risk. Knowing your customers and the markets in which they invest are two of the simplest and most basic tools of understanding risk. Living, working and playing in the same community as your Borrower is a surefire way to know their business environment. It is also the best way to know what your Borrower’s reputation is for paying his or her bills. This knowledge of the customer is one of the Five Cs of Credit that Lenders use to determine risk levels. These measures incorporate both qualitative and quantitative analytical tools as follows: 

    Character - The Borrower’s history of how they pay their bills; 
    Capacity - The quantitative measure of whether the Borrower has sufficient income to pay its debts; 
    Capital - Also known as equity. Generally, the higher the equity contribution, the lower the risk to the Bank; 
    Collateral - An alternative source of repayment if cash flow cannot be relied upon to pay the debt; and 
    Conditions - Also known as loan structure. This refers to both the return built into the investment (the interest rate being charged) as well as the conditions placed on the accommodation to ensure the Bank is repaid (hopefully in full!).

This last category, Conditions, is also a means by which Banks can manage the risk to a level commensurate with the return. Loan structure is considered by many to be the most effective tool Banks have to manage risk. This is because the elements of risk in a transaction can be addressed selectively, with fine tuning used to address those aspects of the transaction that are perceived to be too risky for the return. Some of the more common structural tools used are: 

    Loan-to-Value Ratio – Determines the level of Borrower equity in the transaction. The Bank hopes that the Borrower’s own cash into a deal will make it harder for the Borrower to walk away from an investment if times get tough (also known as “having some skin in the game”); 
    Debt Service Coverage Ratio - Establishes excess cash flow criteria for the investment. This calculation takes the cash flow of the business or investment property and requires there to be a “cushion” over the debt service expense. This measure also ensures the investment generates a return to the owner, otherwise there is little incentive to retain the investment. This also makes the investment more attractive to any potential investors looking to buy the business or property, thereby increasing the marketability of the asset if the Borrower sells or the Bank forecloses; 

    Financial Covenants – These are typically used to either keep the company’s financial condition from deteriorating from the levels reported at the time of the loan approval or improving certain financial measures to a more acceptable level. Some of these covenants are: Restriction on distributions not exceeding earnings, establish a maximum Debt to Tangible Net Worth (the ratio of total liabilities to tangible net worth), restrict Capital Expenditures, establish limits on obtaining additional debt, require a minimum Net Worth (either to retain or build equity in the Borrower), etc. 
    Subordination of Officer Debt – Requires the Bank loan be paid prior to loans made by Officers of the company being repaid. Since the Officers have the potential for a higher rate of return on their investment (interest and profits), the rationale is that they should wait until the lenders (Bank) who receive a lower return are repaid; and 
    Borrowing Base – Allows borrowing on Lines of Credit based on the level of Accounts Receivable, Inventory and Work in Progress (WIP). This aligns the borrowing to the assets needed to be converted to cash to repay those borrowings.

These are just a few of the tools used to manage the perceived lending risks associated with commercial loans. These tools, if used judiciously, actually help to strengthen the Borrower’s financial condition and can serve to make the collateral more valuable (in the case of a strong Debt Service Coverage ratio).

The relationship between a Borrower and their Bank is a contract –both parties must derive value for the relationship to be a healthy one. A mutually beneficial relationship is the ultimate goal, so by strengthening the Borrower through reduction of lending risk, a stronger relationship is created which benefits both parties.