Solid Practices and Early Warning on Commercial Loans

No bank has been untouched by the deteriorating economy. At times like this, which most of your commercial bankers have never experienced, what are the changes you can make to improve your "early warning" and prevent future losses?

Below is a laundry list of items you might consider. Many of these old standbys you already know, but it's always nice to be reminded,

• Commercial bankers should not do site inspections for construction loan disbursements. This is bad business, period full-stop.

• Require your RMs to visit ALL their customers, even the small borrowers, regularly, at their place of business. There is no substitute for eyeing the place, seeing the look in the borrower's eye, observing customer traffic or lack thereof, how neat the place is, inventory levels etc.

• Act quickly: get the cash while it's still there and avoid "dead man walking" loans. Timing is tricky, since you don't want to push an ailing borrower over the edge to the critical patient list, yet, more often than not, the price of waiting is heavy in terms of losses.

• Consider placing a lien on a borrower's tax refund if personal guarantees are involved. Tax refunds are often disputed by the defaulting borrower, but pre-empting that dispute and putting a lien on the money due is first step to collection.

• Avoid Shared National Credits if you can, since they do not enhance your franchise value (although they CAN contribute to profitability AND to losses). Especially when risk-based capital is so scarce and borrower demand growing (for both credit worthy and non credit worthy prospects), spending your capital wisely on relationship that will give you best relationship growth opportunities and long-term franchise value.

• Be well prepared for the examiners, and treat them as if they're your best friends. A good relationship with the regulators is priceless. Have those books containing the information they requested neatly organized for them and, if possible, give them their own room so they can do their job in comfort.

• Come to grips with your non-performings before the regulators do. First, recognize and reward RMs for early warning on credit problems. Then, add significant "dings" to your commercial bankers' incentives if they aren't the first ones to point out credit deterioration. Both are important step toward building an early warning culture.

• Reduce pressure on loan production; increase pressure on. relationship banking including both loans and deposits. We've all asked for deposits as a part of the loan deal, yet many have accepted future funding (which often did not materialize), and few have loan-to-deposit expectations (a.k.a percent self funding) from their commercial bankers. Having the borrower open an inactive or low balance checking account does not really fulfill the "relationship" element of the equation.

• Monitor lines-of-credit trends, especially out-of-the-ordinary draws. Report percent outsdtandings out of commitments and lines trends; those are strong early warning signals.

• Review each banker's portfolio quarterly with special focus on risk ratings. Shining the light on individual performance facilitates recognition of the heroes and appropriate action for the laggards.

• Conduct quarterly an in-depth review of the top twenty borrowers for each banker. This will enable you to better understand the dynamics of your largest borrowers and take the right steps to support them or pull the plug if need be. Your RM involvement is key.

• Measure, report on and reduce exceptions, both critical and technical. Goal percent of both exceptions by total loans outstandings; larger loans (say, $1 million); and by RM. There is much insight in these numbers.

• Tighten accountability for RM follow up with their borrowers by increasing the frequency of your in-person contact with them.

• Use your audit or loan operations department to examine and enforce covenant execution to ensure you indeed do have the safeguards and coverage in place that you thought were contracted for as a part of the loan agreement.

And here are some thoughts on how to avoid future problems:

• Align RM incentives with your strategic intent. If relationships are what you're after, pay for those and for cross-selling, and reduce meaningfully the incentives for pure transactions. If you really mean it when you say "bring me deposits", don't approve loans without a minimim level of self-funding. And if you wish to reduce your average loan size, require your RMs to grow their portfolio within a certain loan size average in order to get compensated. Same for prepayment penalties, meaningful floors (as opposed to, say, 4%), etc. etc.

• Make sure new loans are "as billed". Many new loans are approved a certain way, but some of the clauses don't find their way into the loan agreement. This sounds preposterous, but can be commonplace among community banks. Closer inspection of loan documents and major consequences to RMs whose documents do not reflect the loan terms as approved at loan committee or by the signature process will help prevent future violations.

• Give credit trainees, management interns and future RMs some time at the workout desk. Most banks did not have a workout department for the past twenty years. Most RMs never experienced the economic earthquake we're undergoing today (unless they lived in Texas in the 80s). Use this unique time to show them what borrowers can be like and how to safeguard against losses in the future. It's time (and money) well spent.

• Define limits not only as volumes of individual loan categories, but also across loan types that are heavily correlated. Example: auto dealers and auto parts; construction, cement factory and contractors

• Remember that a 5% portfolio concentration is HIGH and can come back to bite you. While it may seem small, when an entire sector declines, the absolute levels of non-performing assets can be overwhelming.

• Do not lend money to companies who lend to others in a way you wouldn't. In other words, companies whose practices violate your own credit philosophy should not be able to borrow from you.

• Conduct regular "post mortems" on failed credits and modify your credit policy to reflect lessons learned. Among the areas where I'm seeing tightening are:

  • Relaxing the requirements of spec building phase-ins
  • Lesser liquidity covenants
  • Consider contingent liabilities
  • Link liquidity to spec volumes for builder loans

• If you have to work too hard to make the loan, don't make it. Trust your gut and consider repeated attempts at structuring a big red light.

• If the pricing is too sweet, there is a reason...

20/20 hindsight is perfect, and it's easy for me to write the above list when non-performing loans are skyrocketing system-wise. However, if we put some of these preventive measures in place, there will be less pain the next time we get hit by a tornado like we have now, and your balance sheet and franchise value will be stronger.