The Key of Having Sound Commercial Lending Policies

The financial crisis is getting smaller and smaller in the rear view mirror and now we see many lenders are beginning to go back to some of the lending practices that got community banks into so much trouble. This may be especially concerning when you consider where we are in the economic recovery. History demonstrates that most bad loans are made in the last two years of a recovery process. Given the length of the current recovery period, we may be in that two year window now.

Problematic Lending Practices

Many community banks are currently sitting on lots of liquidity due to the Federal Reserve’s unprecedented expansionary monetary policy. Some banks are deciding that the best way to preserve and grow profit margins is to grow their small business and income property loan portfolios. There still aren’t lots of great small business lending opportunities out there. Plus, community banks are facing heightened competition from marketplace lenders and cloud funding sources like LendingClub.com and OnDeck.com. With more competition for a shrinking base of quality borrowers, some lenders are once again doing the kinds of things that could put us right back where we started. These questionable practices include:

• Putting small businesses in the wrong loan products.
• Reaching for yield by extending maturities on fixed-rate loans.
• Regarding collateral more aggressively and becoming too dependent on collateral and owner guaranties.
• Citing multiple exceptions and variances to approve debatable loans.
• Failing to institute and enforce realistic expectations with borrowers when it comes to financial performance and reporting requirements.
• Becoming more aggressive in their loan underwriting processes.
• Inappropriately financing working capital.

Review the 5 C’s of Credit

In this environment, it might be wise to go back and revisit some of the fundamentals of sound commercial lending. In particular, take time to revisit the profound 5 C’s of credit:

1. Character — Look not only at the character of the business owner, but also at the character of key executives. Do they have a strong reputation in the community and within their industry?
2. Capacity — Dig into a borrower’s financial statements to define the company’s debt service capacity and thus gauge its ability to safely assume more debt.
3. Capital — How much cash and hard assets does the business have on hand? How long is its cash conversion cycle?
4. Collateral — Don’t take shortcuts when it comes to collateral requirements and valuations, even if it requires the owner to pledge their personal residence to cover the loan.
5. Conditions — Consider business and economic conditions nationally, in your local geographic area and in a borrower’s particular industry.

Don’t let this problem surface in your portfolio. Now more than ever is a time to stress fundamentally sound lending with your team. If you’d like to discuss sound commercial lending fundamentals in more detail, contact The Whitlock Company at 417-881-0145.