At a time when customers want more personalized service, financial institutions must balance credit risks with the importance of maintaining and nurturing customer relationships. Doing this with business customers can be tricky because their ability or willingness to provide financials can vary from business to business, from year to year, and regulators are scrutinizing lending policies more than in the past. While business customers may desire this kind of “relationship-based lending,” it can only be adopted alongside appropriate credit risk management processes.
Relationship-based lending can be defined as financial institutions using personal knowledge of the business borrower over time to overcome issues of information opacity. This personalized, local approach allows for greater flexibility in loan approvals and, by numerous accounts, business banking customers are more satisfied with their financial institutions when they experience personalized service. Smaller financial institutions have traditionally held an edge over bigger financial institutions in this regard given their smaller customer base and proximity to the community.
Some studies have found that the longer the duration of a relationship between institution and borrower, the greater the credit availability and the lower the collateral requirements for the borrower. Others have noted that establishing a relationship with a borrower boosts the likelihood of winning the borrower’s future loan business. Businesses may be more willing to pay a slight premium to borrow from a local bank with which they have a relationship. Many financial institutions also recognize that deeper, longstanding relationships can mean more revenues from multiple product lines and referral business.
The key to effective relationship-based lending is to utilize objective measures of credit risk and to build customer as well as lending staff expectations that the measuring process is ongoing and no longer optional. Even banks and credit unions that have longstanding relationships with business borrowers can benefit from incorporating standardized, forward-looking methods for quantifying credit risk. These benefits include improved customer service, financial performance and regulatory compliance.
Developing or enhancing objective measures should involve the three following components:
Outlining key credit risk metrics and thresholds. Developing objective credit risk measures starts with the board of directors and senior lending staff, who must outline policies and goals regarding lending as they consider the organization’s overall objectives and risk tolerance. Because each institution’s risk appetite differs, the specific thresholds under and above which they will or will not make loans also vary. Regardless of the specific thresholds, the following objective measures of credit risk are often considered key pieces of loan policies to be implemented across the institution.
- Business credit scores
- Personal credit scores
- Probability of default metrics
- Debt service coverage ratios
- Loan-to-value ratios
- Overall ratio analysis
- Global cash flow analysis
- Uniform Credit Analysis (UCA) cash flow analysis
Balancing the implementation of policies that include well defined calculations and thresholds for the above metrics with a process for evaluating additional, qualitative factors, which may be uncovered by the loan officer or relationship manager in working with the client, is the first step in balancing risk management with relationship-based lending.
Defining staff roles and responsibilities, or specifically outlining in policy who does what during the initial credit analysis, loan review process and the post-funding analysis. One particular area of concern should be post-funding analysis, which can slip through the cracks if responsibilities aren’t spelled out regarding who must obtain financial statements annually, who must conduct the financial statement analysis annually and who must conduct a global credit analysis annually. Failure to do this can result in a lesser degree of post-funding due diligence. While regulators may be letting some smaller, stronger financial institutions get away with that for the moment, the banks have very little room for error.
Another way to improve standardization is to centralize the credit analysis function and separate it from the loan origination effort. Having a centralized team of analysts applying a single methodology to the process provides more standardization than a dozen loan officers with varying viewpoints and methodologies. It may also allow the relationship manager to better communicate the lending process and standards.
No matter the staffing structure, it’s important for staffers to be properly trained in not only the institution’s products and policies but also in understanding all of the client’s needs in order to offer relationship-based solutions. Time and again, relations turn sour when financial institutions promise more than they can deliver; incorporating consistency from the outset can prevent that.
Implementing standardized credit risk solutions. No matter whether the analyst and lender functions are separate or together, or how the analysis responsibilities are divided, financial institutions can take some of the guesswork out of a relationship-based approach by utilizing standardized solutions like financial-statement spreading applications or default models.
As many financial institutions look to tap into their existing community relationships by ramping up commercial and industrial lending (C&I) activities, experienced lenders and credit analysts may be in short supply and some financial institutions may be blazing new risk territory. If a financial institution is new to C&I lending, they may not understand which industries are riskier or where they want their exposure. A standardized solution that calculates ratios will provide quantifiable risk rankings in certain industries so you’re not just shooting in the dark and can justify your positions if examined.
Developing consistent analysis and documentation should show examiners that the financial institution is on top of things and that each borrower is being evaluated in the same way.
Ms. Biery is research specialist for Raleigh, N.C.-based Sageworks, a financial information company and software provider. She can be reached at [email protected].
