The U.S. is currently experiencing the longest economic expansion in history, but for how much longer? Recent signs, such as the inverted yield curve, have left many San Francisco Bay Area and Silicon Valley chief financial officers (CFOs) predicting an impending economic downturn. In fact, nearly half of CFOs in the U.S. expect a recession by the end of 2019 – and eighty two percent believe a recession will have begun by the end of 2020, according to the Duke University/CFO Global Business Outlook survey. Since the financial markets can rapidly deteriorate without notice, it’s vital to prepare early to help strengthen your company’s future. Here are some actions, if taken now, that can help you plan ahead:
Reevaluate your risk scoring model
One of the most important ways to ensure your financial institution is making good loans is to create a consistent risk scoring model so that all loans are assessed in the same manner. When creating a risk scoring matrix, it should be designed so that a consistent measurement can be applied to similar loan types. An ideal model will apply a balance of objective and subjective factors that reflect the borrower’s ability to repay the debt. Although objectivity is important for consistency, you want to avoid models that are too objective. This leaves very little control over the outcome. However, a model that is too subjective has no consistency and creates additional risk in the loan portfolio that is hard to quantify.
Common objective factors to include in your risk scoring model are comparative ratio analysis based on industry, loan-to-value ratios, credit scores, and payment history. Common subjective factors includes strength of guarantors and strength of management team. The key is to strike a balance that drives consistency but leaves enough flexibility for the lenders to still get deals done that fit the risk profile of the financial institution.
Bolster the 5 C’s of Credit
The 5 Cs of Credit – capacity, capital, conditions, collateral, and character – have been the foundation of assessing a potential borrower’s credit worthiness. Understanding the borrower’s or businesses’ ability to repay debt, level of debt, plan for funds, and collateral available plays an important role in evaluating loan applications. Your institution’s lenders should assess the borrower’s ability – and willingness – to repay the loan, as well as the protections available if they don’t.
There are four key financial variables you may leverage to represent a company’s credit risk profile and to predict their likelihood of default. These metrics include debt service coverage ratio, net profit margin, quick ratio, and loan to value. These variables provide a unique indicator of a private company’s financial standing and has significant implications when evaluating credit risk:
Debt Service Coverage Ratio (DSCR): The higher a firm’s debt service coverage ratio, the greater its ability to produce enough cash to cover debt payments. While DSCR will vary among borrowers, aim for at least a 1.15 ratio.
Operating Margin: Net profit margin shows the profitability of a company by dividing Operating Profit by total sales. The higher the profit margin, the more likely the business will be able to remain resilient in periods of unexpected losses. A lower Operating Margin, on the other hand, could indicate a company’s pricing strategy, sales, volume, or expenses are out of line compared to others in the industry.
Quick ratio: This is also called the Acid-Test Ratio. Lenders often look to Quick Ratio because it shows the percentage of a firm’s debts that could be paid off by quickly converting assets to cash. The more liquid a firm’s assets, the better equipped it is to adapt to changing conditions in the business environment. Ideally, a quick ratio should be roughly 1:1, meaning assets are able to cover short-term debts. To calculate the Quick Ratio, divide cash, cash equivalents, and accounts receivable by total current liabilities.
Loan-to-Value (LTV): Loan-to-Value shows the size of the loan compared to the proposed collateral, or the percentage of the principal value covered by the appraised collateral. Lenders rely heavily on LTV because it shows the risks involved with issuing the loan. Typically, the lower the LTV, the lower the risk. Borrowers with higher LTVs have committed fewer resources, and therefore, in the event of default, would have less collateral to supplement loan payments.
Create Scalable Growth
Over half of lending and credit professionals agree that increased competition is degrading prudent credit risk practices in the banking industry, according to Abrigo’s 2018 Credit Risk Readiness Study. To encourage safe, sound, and sustainable lending, it may be time to rethink current strategies and look to new processes to encourage consistent and objective credit risk analysis.
Your company is unique and has its own comfort level for risk, so it’s important to adjust your strategies accordingly. Loans must pass regulatory scrutiny, but loans officers should also have the flexibility in loan decisioning within the parameters of the company’s risk tolerance.
In today’s competitive environment, it can be tempting to make more risky loans for the sake of potential profitability, but this type of risk could lead your company down a dangerous path, especially if an economic downturn was to occur. To grow your loan portfolio safely and soundly, consider the benefits of software to create scalable processes. From risk rating and loan pricing to spreading loans and creating compliant loan documentation, today’s technology can enable your financial institution to complete time consuming, complex tasks more efficiently and more accurately.
Given this long period of economic expansion, it may be difficult to imagine what another economic downturn would be like. Whether that is six months or six years away, it is important to be prudent in credit risk analysis and ensure your institution is making smart loans in order to grow safely and soundly. Make sure your institution is keeping a pulse on its credit risk strategies and is always assessing new ways to bolster and support those policies.
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