The Importance of Sound Commercial Lending Policies

Philosopher, essayist, poet, and novelist George Santayana is known to be the originator of the quote: “Those who cannot remember the past are condemned to repeat it”, which might be appropriate to describe what’s going on in some segments of commercial lending today. As the financial crisis grows more distant in the rear view mirror, many lenders are starting to revert to some of the lending practices that got community banks into such trouble in the first place.

This may be especially concerning when you consider where we are in the economic recovery. At nearly seven years and counting, the current recovery (which started all the way back in 2009) is getting a little long in the tooth. History demonstrates that most bad loans are made in the last two years of a recovery — and given the length of the current recovery; we could be right in the middle of this timeframe now.

Questionable Lending Practices

Many community banks are currently sitting on lots of liquidity due to the Federal Reserve’s unprecedented expansionary monetary policy. As they watch their interest margins and fee income drop, some are deciding that the best way to maintain and grow profit margins is to grow their small business and their commercial real estate (CRE) portfolios.

However, there still isn’t a lot 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 reverting back to the kinds of lending practices that could lead to another round of problem loans. These questionable practices include:

  • Becoming more complacent in their loan underwriting processes.
  • Reaching for yield by extending maturities on fixed-rate loans.
  • Offering more interest only financing terms, versus traditional principal and interest amortized loans.
  • Valuing collateral more aggressively and becoming too reliant on collateral and owner guaranties.
  • Waiving of guarantees and taking a more asset based lending approach.
  • Citing multiple exceptions and variances to approve questionable loans.
  • Approving more loans out of their more traditional defined markets.
  • Failing to establish and enforce realistic expectations with borrowers when it comes to financial performance and reporting requirements.
  • Inappropriately financing working capital.
  • Not properly identifying contingent liabilities and trends of their borrowers’ customer concentrations or gauging their financial leverage not performing annual relationship reviews and property inspections.

Revisit 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 the time to reexamine and re-emphasize with your lenders the tried-and-true 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? Do they take responsibility for their actions and outcomes instead of trying to blame others when things don’t work out?
  2. Capacity — Dig into a borrower’s financial statements to determine the company’s debt service capacity and thus gauge its ability to safely assume more debt and withstand adversity.
  3. Capital — How much cash and hard assets does the business have on hand? How long is its cash conversion cycle? And does the owner personally have some “skin in the game”?
  4. Collateral — Don’t take shortcuts when it comes to collateral requirements and valuations. This includes requiring that owners pledge their personal residence as collateral if this is necessary in order to properly secure the loan.
  5. Conditions — Consider business and economic conditions nationally, in your local geographic area and in a borrower’s particular industry.

Don’t wait until problem loans start to surface in your portfolio to take action! Now is the time to stress the fundamentals of sound lending with your commercial lending team.

For more information, contact Jay Lucas at jlucas@pkm.com or 404-420-5737.