A Reminder on Sound Underwriting
Lending requires risk-taking; prudent lending requires a careful and critical assessment of risk. Bankers and bank supervisors, we can say in retrospect, underestimated the risk of loans, particularly those related to land values, before the financial crisis. Net credit losses for Ninth District banks nearly quadrupled from 2000 to 2010. This is not the first time we have underestimated risk (e.g., the downturn in agriculture-related loans in the 1980s that led to many bank failures). Bankers also report that while post-crisis loan growth remains weak, competition for qualified loans is fierce.
Both factors motivate this article’s review of a few key underwriting processes banks should use when evaluating borrower repayment prospects. Breakdowns in stressing the risk of repayment and assessing the strengths/limitations of guarantors and collateral lead to many of our findings on credit administration. Banks with effective processes in the following areas are less likely to have such findings or experience significant problem loan volumes.
Repayment stress testing—Analyzing historical and prospective cash flow in relation to the required principal and interest payments (debt service ratio) serves as an underwriting starting point. Stress testing goes further by assessing a borrower’s ability to repay the loan according to the contractual terms under adverse conditions. We expect stress tests to consider factors such as these:
- Unexpected reductions in revenue.
- Unfavorable movements in market interest rates, especially for borrowers with high debt burdens.
- Deterioration of the value of collateral, guarantees or other potential sources of principal repayment.
Global cash flow analysis—Banks often structure loans with a principal or affiliated company guaranteeing a borrower’s debt. Banks must assess the level of strength provided by the guarantor(s)—both at initial underwriting and in ongoing assessments such as annual reviews—to understand the risk of the loan. We have found that such reviews may find guarantor limitations: Consider a guarantor deriving a significant portion of cash flow from the sale of lots in one development.
Collateral analysis—Banks must understand the value of collateral—whether collateral is the primary or secondary source of repayment—to understand the risk of a loan. Understanding the value of collateral requires a bank to answer some basic questions:
- What is it?
- Where is it?
- What is its condition?
- What is it worth (and what is it worth if the bank must liquidate it)?
Important breakdowns can occur in collateral analysis when those producing the loans also carry out the collateral assessment; objectivity is critical. Banks also should not let their collateral analysis become outdated. Management should review their answers to the questions at least annually for operating lines and perhaps less frequently for term loans.
Any questions from state member banks regarding the discussion above can be directed to their relationship manager.
