Some Advice on Trusting Today's Small Borrower: Don't
There has been much in the press recently about bankers retreating to their traditional core business: serving consumers and small to medium-size businesses.
Lenders joining this retreat should be aware that times have changed since their flight to the land of Third World, real estate,
and HLT loans. and HLT loans.
Financial misrepresentation by borrowers, and even outright fraud, have increased.
Bankruptcy and Fraud
A Washington Post article reported that bankruptcy filings were rising at an 18% rate. Officials in Los Angeles estimate that fraud was involved in more than 40% of bankruptcy cases there.
Gone are the days when lenders could generate business solely through referrals from existing clients whose families have been with the same bank for generations. Today's bankers are doing more advertising and "cold calling." They are also meeting prospective borrowers through new and indirect channels.
Obviously, bankers don't know these prospects very well. Yet many lenders continue to use traditional due diligence practices in evaluating their loan requests.
Taking Too Much on Faith
For example, private bankers and lenders to privately held businesses rely on unaudited personal financial statements in their credit evaluations of borrowers or loan guarantors.
Few lenders independently confirm the accuracy of items on these statements.
Therefore, many credit analyses are based on a statement compiled and reviewed only by the prospective borrower's accountant.
But an unaudited statement is only as reliable as the data supplied to the accountant. Further, lenders usually assume information they obtain to confirm a financial statement is valid and accurate -- even when it comes, as it often does, from the borrower.
The Limits of References
Likewise, bank and character references are often provided solely by the client, who would be unlikely to name any source that would give a poor reference.
Some lenders dismiss the deficiency in their credit evaluation procedures, arguing that they do indeed know their borrowers.
After all, part of their evaluation may involve calling mutual friends and acquaintances about the prospective borrower's character and standing.
If these contacts say the borrower is a "good guy," the lender trusts that the financial statement supplied to get a loan is accurate.
Such trust is not warranted in today's environment.
More Show than Substance
Lenders should also ask their contacts if they have direct knowledge of the borrower's financial condition.
Invariably, the answer will include descriptions of big houses, expensive cars, well-catered parties, perhaps even a country club membership or two.
But experienced lenders know that external shows of success do not guarantee financial solvency. And loans driven by "the halo effect" -- that is, loans provided to individuals on the basis of social and political status or connections -- too often end up in workout.
With advancing technology, falsified financial documents are increasingly easy to produce. Prospective borrowers are less driven by the need to develop a long-term relationship with any one institution.
They are also more aware that an unaudited personal financial statement, a (falsified) copy of a tax return or other supporting documents, and a credible friend or two to vouch for their character, can get them a loan at many notable lending institutions.
Given these factors, many bankers are walking blindly into another lending debacle.
Most loans that wind up in workout do so because of a sudden drop in the borrower's cash flow, often "due to unforeseen circumstances. Earlier independent verification of items on the financial statement might have revealed that this particular borrower never had enough cash flow to meet obligations, even before the loan was made.
Lenders could increase their profit spread by as much as 100 basis points simply by changing credit evaluation procedures.
Those who use marketing to attract for clients but fail to adjust their traditional credit-evaluation procedures will experience ever higher loan losses and lower profitability, since the problem of financial misrepresentation will surely grow.