Today's credit environment is one of the most challenging industry leaders have seen in decades, and while the headlines focus on the subprime loan crisis and the downward spiraling residential real estate market, complications in small-business lending may emerge as the next major financial threat.
Banks should be evaluating four key factors in understanding their risk: credit scoring model rules and assumptions, secondary sources of repayment, entity documentation, and insurance coverage.
Since many banks use scoring models established in years past to approve small-business loans, how these loans will perform in the current and rapidly changing environment may be uncertain.
With so much uncertainty surrounding the credit market, banks should be moving to make sure the business rules supporting their scoring models, whether internally developed or licensed from a vendor, reflect their current credit policy.
As a starting point, the chief credit officer should certify the model as being consistent with the policy. Simultaneously, governance related to changes and modification should be reviewed to ensure that only authorized personnel can change the business rules in the model. The models should be reviewed independently, at least semi-annually and more often during volatile credit markets.
In addition, secondary sources of repayment should be reassessed. This important risk reduction mechanism, though required for approval for many loans, often is not scrutinized as diligently as it should be when the loan is underwritten.
A close review may reveal that the secondary source of repayment is actually real estate. As a result, many loans should probably be assessed as real estate loans. This dependence on real estate for repayment clearly elevates the risk profile.
To understand the real credit risk of these loans, loss reserves need to be examined. Up until 2006 many banks were looking at reducing their reserves. While the accountants and regulators debated the proper level of reserves, most banks decreased reserves — significantly in some cases. Because of the possibility that lenders have more real estate loans than they realize, small-business and commercial loan portfolios should be reassessed independently with respect to loan-loss reserve calculations.
Also, the past several years have witnessed increased laxness on the part of lenders in getting and updating documents from their customers. Relationship managers, because of inexperience, laziness, or a desire not to bother the customer, fail to get updated business entity documents and authorizations. As a result, the lenders cannot pursue legal protections that normally would be available.
Related to this point is the increased practice of not getting timely and updated financials from customers. Not only is this required by most loan covenants, but it is also good business practice, since it provides insights into the client's overall business health.
A good business process also includes documenting any changes, such as emerging trends (e.g., reduced revenue), changes in management personnel, or new competitive factors. This point seems obvious, but it is another area that has received short shrift in the rush to increase loan production.
The last risk factor, though certainly not the least troublesome, is insurance. There are actually several issues related to insurance — all of which can protect both the customer and the lender from financial loss.
Today's more difficult economic environment may tempt some business owners to cut corners, especially when it comes to insurance. This may mean trying to self-insure without the financial wherewithal to do so, or not buying or renewing life insurance for key employees. A good banker should conduct periodic "check-ups" with their customers. Not only will this enhance the relationship and understanding of the client's business, but it will also identify areas that may require adjustment or closer attention.
Today we are without a doubt in a higher-risk environment for all types of lending. Small businesses are especially at an increased risk.
A continued weakening of the economy could cause further and potentially widespread damage in small-business lending portfolios. Therefore, it is imperative that bankers do an immediate "credit recheck" to ensure they have the four risk factors comfortably under control.