The Weekly Adviser column recently received a letter from Peter J. Vann of the 50-year-old firm of Crowe Chizek in South Bend, Ind. The company has developed an early warning system for bank lenders, called Lending Advisor.
Mr. Vann makes the following observations:
"Managers and credit policy administrators are trying to cope with burgeoning problems with little or no prior training or experience, while banks are trying to manage credit policy with methods that may be too narrowly focused.
Earlier Early Warning Systems
"On top of this, there are few guidelines for what constitutes a good credit risk. Recently, one of our executives made the following comment:
|While the interest in knowledge-based rating systems is a relatively recent phenomenon, these tools have been available for commercial lenders since the mid 1980s. The first systems were hailed as a wonder of high technology, promising to solve the ills of poor credit quality and declining productivity in commercial lending.
|These claims, however, proved false. Early systems were difficult to use, expensive and nearly impossible to integrate into existing systems environments.
|Technology, however, has improved to the point where knowledge-based systems are practical and affordable risk-rating tools for small-business lending.'"
Mr. Vann tells the story of one bank that suffered a loss on a corporate loan. After the fact, the bank learned that had it been using Lending Advisor, there would have been warnings 18 to 24 months earlier that the credit was headed for trouble.
He goes on to say that, "Most of the PC systems banks have installed have produced pins in back-office productivity. However, little has been done to introduce gains in the credit approval process.
"The knowledge-based environment is in the process of emerging as a new generation of credit analysis software, which will automate risk assessment.
"Being able to spot credits headed for trouble would have enormous impact."
Not Here to Simply Plug
This column certainly does not want to plug any one commercial system over another, but I thought if I asked Mr. Vann to tell me what criteria his firm uses to do this early warning analysis, it would be useful to all community bankers.
I called him and immediately received a letter from Mark L. Laudeman, a senior manager with Crowe Chizek.
Lack of Training
Mr. Laudeman writes:
"Analyzing the cash flow of a business entity is one of the most fundamental aspects of credit decision-making. Yet, many lenders have simply not been given proper training in the use of cash-flow information to assess the financial position of a business borrower.
"Lenders end up relying on the information they understand and are comfortable with. They thereby wind up giving too much emphasis to factors that are not good measures of credit risk - things such as, collateral, character, and payment history.
"Lenders are often not in the practice of getting the information needed for analyzing credit risk. The financial information may be incomplete and of poor quality, and once the loan is made, this information is typically not updated for periodic monitoring.
"A related problem is that lenders are not asking some important questions about the borrower's business. For example, lenders are not accustomed to probing into the reasons for changes in balance sheet or income statement accounts. Neither do lenders usually look at the borrower's financial performance in comparison to the industry averages.
"Additionally, the risks related to the borrower's industry, the borrower's competitive position, or the quality of its management are often ignored completely.
Old Habits Die Hard
"I think there are a couple of reasons why lenders have not done a good job in obtaining quality information from their borrowers:
"Simply put, they are not in the habit of using this information and they fail to see the value in the extra diligence required to get it.
"Also, it is difficult, sometimes impossible, to get complete and accurate information from the small-business borrower.
"However, if lenders were asking for this information, I believe that many small businesses would do what it takes to comply with these requests.
"Success in lending is driven by the quality of personal service. Therefore, banks usually hire and train lending officers to be servants to their borrowing customers. The role brings with it an inherent optimism, a bias in favor of the customer.
"Larger banks have credit officers who may have little or no customer contact and who join with the lender to bring objectivity to the credit decision. Lenders who lack this level of support are more apt to overlook a weakness or a problem, or they may play down its importance or its likelihood.
"Studies have shown that lenders spend a surprisingly small amount of time in revenue-generating activities, like researching and contacting borrowers, and a disturbingly large amount of time in credit administration, like paperwork.
"When the administrative tasks are examined closely, it is clear that the largest share of this time is in organizing and presenting information. "
For Community Banks, Too
Naturally, many community bankers will conclude that the problems Mr. Laudeman presents are too complicated and the systems of correction are too expensive for their own banks.
But my phone conversation with him left me with a different conclusion - a conclusion buttressed in an article entitled "Automating Early Warning Detection" that appeared in the April 1993 issue of the Robert Morris Associates' Journal of Commercial Lending.
I concluded that early warning is not so complicated. Rather, it involves comparison of various ratios and positions of the borrower with those of other firms of similar size in its industry.
And the data to do so is readily available to members of Robert Morris Associates, the industry association - and the data can be obtained without consultants or intermediaries.
As with so many other technical developments in banking that seem to be far too complicated to the community banker, Mr. Laudeman's discussion on early warning systems show that just asking the right questions and putting the loan officer's attention on the right comparative data can go a long way toward achieving the goals of adequate early warning on loan problems.
Mr. Nadler is a contributing editor of American Banker and professor of finance at the Rutgers University Graduate School of Management.