In today's uncertain economic climate, properly managing and collecting on nonperforming loans can mean the difference between strong liquidity and being liquidated.
Community banks should anticipate finding nonperformers in numerous business sectors. Past cycles have tended to be industry-specific, having their greatest impact on only one sector of a bank's business loans. This time around, community bank executives must plan to tackle nonperforming loans across the board.
In the face of uncertainty, anticipating both the best- and worst-case scenarios is a bank's greatest defense.
Stress-testing the bank's portfolio is crucial for properly anticipating what challenges might materialize. Bank executives must take a close look at all borrowers and ask the essential and basic questions about what products they make and how the economy is likely to affect that business.
The moment a bank anticipates, or sees, signs of nonperformance, it is absolutely essential to meet with the borrower in person and ask the tough questions. Executives must assess their client's ability to understand and manage the situation.
The important conversation needs to happen early in the process, to determine whether the borrower has a plan to modify its business strategy to match the current market and how it is managing cash flow.
The adage "your first loss is your best loss" is generally true; once it is clear that a loan is nonperforming, it should be dealt with quickly. This can present a real challenge for community banks, which in general maintain personal relationships with their clients and typically do not have stand-alone workout departments.
The partnership formed between an account manager and a borrower may put the manager too close to the client to be effective in collecting on the loan.
The CEO and the credit chief need to step in quickly at that point and turn over the account to a professional who is sufficiently removed from the client to execute a workout strategy.
Bankers should be prepared to seek outside advice, including legal counsel or other types of consultants. Because most community banks lack the benefit of an independent workout department, seeking advice from the appropriate consultants can often highlight tactics and ideas that the bank's executive team has not yet considered.
If the bank is participating in a loan with another lender and it becomes nonperforming, soliciting communication with this partner on the loan's status is crucial.
It is prudent for bank executives not only to advise and inform a lending partner of difficulties but also to leverage the lender's experience to help collect. Community banks must mitigate risk with lending partners to avoid the very real threat of lawsuits, which can be filed if a lending partner believes a loan was mishandled.
Employing effective tactics will help community bankers manage potential threats to the bank's stability and collect on and manage nonperforming loans. My bank's executive team was able to use these learned tactics to work out a potentially nonperforming loan with a residential builder in Orange County, California. Homes built by the company came on the market much later than planned when the loan was granted. Sunwest executives were quick to act, doing extensive market research in order to anticipate potential problems in trying to sell the homes into a down market.
Bank executives and the account managers also were aggressive in conducting frequent meetings with the borrower, offering the market research the bank had done as a negotiating tool to persuade the builder to reduce his homes' per-unit price. The bank was consistent in letting the guarantor know that, if a loss ultimately occurred, the bank would pursue against the borrower's guarantee.
This is a point some bankers feel uncomfortable discussing, but it helped keep the borrower focused on the issues and personally involved in reaching an acceptable outcome. The borrower, seriously considering the alternatives, was able to review the research and ultimately agreed to cut his unit prices. The loan was paid in full and retired without the bank's suffering any loss.
Responsibility is also a very important factor in a successful workout plan. The CEO and credit chief must hold the assigned banking officer accountable for carrying out the action plan by requiring frequent updates on the loan's status.
It is equally important to recognize when a workout strategy is not achieving the desired result so that the team can discuss alternative strategies or tactics.
Further, community bank executives must be aware that, though a swift resolution is desired, they do not necessarily have to accept the first remedy offered.
Most importantly, in this economy, community banks should revisit their underlying philosophy for establishing loan-loss reserves. Executives must be certain that sufficient valuation reserves exist on the balance sheet against the bank's total loans and that these reserves adequately cover estimated losses in the portfolio.