Amid the recent financial-market volatility, a damaging undercurrent of industry complacency came into view as financing institutions were blindsided by the visible threat of increased default levels and exposure.
For middle-market bankers, the impact of this complacency marks a wake-up call to adopt an aggressive, keen-eyed approach to loan-portfolio management. A heightened sensitivity to loan-portfolio quality can reveal early indicators of potential defaults. It can also provide bankers with a competitive advantage over other institutions that rely solely upon restrictive covenant controls, such as backward-looking interest cover and debt-to-equity ratios.
However, fodder for this improved sensitivity won't come from Wall Street. If we look to Wall Street for answers, we are left with only more questions, theoretical hypotheses and quant-related conjectures. In fact, the current ills look eerily similar to a new strain of bacteria that has become immune to Wall Street penicillin.
Bankers must strengthen their awareness by monitoring loans through the lens of Main Street banking fundamentals-fundamentals that have become lost among 15 years of Wall Street innovation in financial tools, derivatives, hedges and swaps, and buried under hundred-page loan documents. Understand the borrower's known behaviors. Understand the borrower's customers. And understand the borrower's supply chain and cost structure.
Bank CEOs and CFOs should regularly ask for a list of borrowers who are paying outside historical payment patterns, though not necessarily outside of restrictive covenant bounds. This data provides the earliest indication of stress on the business, and functions as the trigger for a meeting between the lending officer and the borrower to explore business conditions and suggested remedial actions.
In addition, CEOs and CFOs should promote a culture that encourages lending officers to communicate potential problems within their book of business before the loan goes sideways and gets turned over to the workout group. In difficult times, lending officers should see themselves as workout-prevention officers. The financial markets changed markedly over the summer, and the subsequent implications for Main Street businesses mandate a fresh look at overall risk, particularly if borrower behavior has changed.
Bankers know that when a borrower's customer base orders fewer products or extends payment terms, this can be a sign of long-term loan problems. Because these symptoms typically appear before covenants are triggered, it is critical to monitor several issues-the accounts-receivable aging; the ratio of sales to AR; and the sales mix in comparison to prior periods. It is easier to pursue discussions with borrowers armed with objective evidence as issues reveal themselves, rather than after the event.
Though it requires additional work by bank auditors, analysts and lenders, this effort will yield the very first signs of potential loan defaults. Friendly reminders to lending and audit teams on the crucial nature of maintaining revenue-stream quality and quantity will keep sensitivities sharpened and ensure appropriate focus of bank resources, particularly during these times of uncertainty.
In today's "just-in-time-with-just-about-everything" global economy, supply-chain interruption can be seriously problematic, as firms in the pet-food and toy industries have learned. For bankers, fresh inquiry into borrowers' supply-chain dynamics is another fruitful avenue for bringing early business-risk indicators to light.
Middle-market borrowers will contend with a slowing, more volatile economy by adding more cushion to their overall inventory and distribution plans and diversifying vendor, supply-chain and related risks. If bankers understand the nature of these changes in the business, they can more clearly assess business and financing risk.
Similar focus should be given to the impact of rising commodity and other prices-including those caused by foreign-exchange exposure-on profitability for borrowers in the manufacturing and transportation industries.
In Chinese mythology, creation occurred when the awakening of the senses brought order to chaos. In the midst of growing uncertainty in business and financing, the banker who is first to awaken all of his senses to understand this chaos will win. Main Street Banker Common Sense has its origins in a heightened sense of awareness, which should serve the industry well as it faces the realities of a new global environment. (c) 2007 U.S. Banker and SourceMedia, Inc. All Rights Reserved. http://www.us-banker.com http://www.sourcemedia.com
