Loan Underwriting Standards - Is It Time to Perform A Reality Check?

written by Kami Bailey

The economic recovery that began in the summer of 2009 passed another significant milestone in April when it became the second-longest U.S. expansion on record. If the expansion makes it to10 years next summer, it will be the longest expansion in U.S. history. While this is good news for the broad economy, but it should raise caution for community banks. Historically speaking, small business loans that go bad are often made during the last couple of years of a recovery—which could be where we are right now.

Regulatory Concerns

The regulators have recently expressed concerns about this issue. In the recently published Semiannual Risk Perspective, the Office of the Comptroller of the Currency (OCC) National Risk Committee (NRC) encouraged lenders to “focus on maintaining sound credit standards within risk tolerances” considering the lengthy expansion. The regulators want banks to understand the potential credit risks that could arise if economic conditions suddenly take a turn for the worse.

Loan Underwriting Practices

One of the concerns that regulators voice involves less-stringent loan underwriting practices that community banks have adopted. Including inappropriate financing of working capital, offering longer-term maturities on fixed-rate loans, aggressively valuing collateral, overly relying on collateral and owner guarantees, offering interest-only terms, and failing to establish and enforce financial performance expectations and reporting requirements for borrowers. Other lending practices the regulators have expressed concerns about include the following:

• A failure by lenders to monitor borrowers’ customer concentrations.
• Lenders granting multiple exceptions and variances to approve questionable credits.
• Acceptance of higher loan-to-value ratios by lenders.
• Acceptance of lower debt service coverage ratios by lenders.
• Adoption of “covenant lite” by lenders—or the tendency of lenders to not enforce covenants that borrowers object to or agree to covenants that have no teeth.
• No longer requiring guarantees or accepting partial guarantees.

Current economic conditions can make it easy for banks to make loans that some borrowers wouldn’t qualify for in a more normal environment. For example, low interest rates, combined with interest-only terms and longer amortizations, may result in an acceptable debt service coverage ratio for borrowers with high levels of debt. And low cap rates can yield higher-than-normal appraised values for commercial real estate pledged as collateral.

Performing a Reality Check

Given these concerns, now might be a good time to perform a “reality check” on your bank’s loan underwriting standards. One way to do this is to adopt a new formula that uses leveraged EBITDA to measure cash flow. Funded debt (senior interest-bearing obligations) / EBITDA Using this formula removes the impact of low interest rates, extended amortizations, and high loan-to-value ratios from the equation. The regulators consider a leveraged EBITDA ratio of 6x or higher to be highly leveraged. Most banks, meanwhile, should want to see a leveraged EBITDA ratio that’s no higher than 3x or 4x.

Re-examine Underwriting Standards Now

Don’t wait until problem loans start to rear their ugly head—by then, it might be too late to act. Re-examining your loan underwriting standards considering the regulators’ concerns could help avoid major problems down the road. Please contact us if you have any questions 417-881-0145.