April 27, 2010
Credit Union Management magazine’s “Loan Zone” column runs the fourth Tuesday of every month.
The business loan documents are signed and the funds distributed. That means your job is done, right?
Wrong. Due diligence and proper risk monitoring and management are crucial throughout the life of the loan to identify potential problems. Early detection is the best way to fend off problems before they become big issues.
Effective risk management practices allow for frequent reviews—or “touches”—of the loan in an efficient and cost-effective manner. The days of simply doing an annual review on a business loan are past. Things can change too quickly in this economic environment.
A Scaled Approach
In our work with credit unions across the country, we see many examples of excellent business lending risk management practices. We also see credit unions where risk monitoring is non-existent. My view is that monitoring activities should be structured to fit the overall risk of the loan. Risk-monitoring activities may vary based on dollar amount, type of loan or the borrower’s industry. Higher risk loans include lines of credit secured by accounts receivable or inventory. In addition, loans made to certain industries, such as retail and hospitality, often carry higher than average risk.
Many credit unions take an all-or-nothing approach to risk monitoring, e.g. “We only monitor loans over $250,000.” While this attempts to balance monitoring efforts with the associated cost, today’s economic climate necessitates a more thorough approach.
I believe the right framework for credit unions is to adopt a risk management system for their business lending portfolio. This holistic view encompasses all the key elements of risk monitoring, both on an individual loan basis and for their overall business loan portfolio. Here are the fundamental steps in establishing a risk management system in business lending.
Tracking
Management must put a process or system in place for timely and effective follow-up. A “tickler system” is the best tool for setting key follow-up dates. Such a system “tickles” employees at the right time for follow-up. A typical follow-up activity would be sending a letter to the borrower requesting updated insurance records. The trick is to then set another tickler for two weeks later to ensure the insurance information has been received. Simply sending the letter is not effective risk monitoring. Actually receiving the information and analyzing it is true risk management.
Analyzing the Borrower’s Financial Condition
The fundamental activity in risk monitoring is reviewing the borrower’s financial situation. This will identify trends compared to the original underwriting and subsequent reviews of the loan. Knowing which way things are heading can help uncover potential problems before they arise. You may notice that a borrower has had a decrease in sales or unusually high expenses, and that is the time to talk with your borrower.
Global Cash Flow Analysis
It is highly important to understand the other obligations of your borrower. Other projects or commitments that go bad may drag down the performance of your good loan. This takes expertise and resources, but again – early detection and fast action are the best methods for warding off loan losses.
Monitoring Industry and Market Conditions
When dealing with commercial real estate, look at the market conditions for the property. Are rents in the area rising or declining? What are the occupancy trends of comparable buildings?
Consider the macro view of your member’s business. Will industry-related government regulations affect the business? Will potential state or federal taxes increase the price of the business’s product or service?
Stress Testing
Stress testing will identify the key benchmarks to watch for during the life of the loan. At what point would the debt coverage be less than sufficient to support your loan payments? How low can the lease income or occupancy rate go before there are potential problems with the cash flow of the property?
Multiple Touches
A variety of automated risk monitoring solutions exist that allow cost-effective monitoring between annual reviews. We recommend at least two “touches” of the loan in addition to the in-depth annual review.
Monitoring the Overall Portfolio
Credit unions must also step back and view the forest (the business loan portfolio) and not just the trees (the loans). Does your portfolio have excessive concentrations in one loan type or industry, or to only a few borrowers? What is the weighted-average risk rating of your portfolio? What are these exposures relative to the credit union’s net worth? Management must take the macro view to accompany individual loan monitoring.
Reporting
I’ve seen cases where management believes the right things are being done, but they really don’t know – and sometimes they only find out when it is too late. Proper management and board oversight is only accomplished with thorough and complete reporting from the business lending area. An effective risk management system has a continuous feedback loop that keeps everyone apprised of both the positive and negative aspects of the business loan portfolio.
To run an effective business lending program, credit union management must break out of the consumer loan mindset and take a holistic view for risk monitoring after the business loan is made. Having solid risk management practices in place will dramatically increase your odds of success in business lending.
Larry Middleman is president/CEO of CU Business Group, a business services CUSO currently working with over 325 credit unions in 39 states. He has more than 30 years of banking and credit union industry experience and can be reached at 866.484.2876.
