KEY UNDERWRITING AND MONITORING CRITERIA FOR BUSINESS LOANS

Transcription

1 KEY UNDERWRITING AND MONITORING CRITERIA FOR BUSINESS LOANS April 12, 2016 Today s Presenter Bruce Hull, Team Resources Bruce Hull has more than 30 years lending experience. His knowledge and ability to communicate have made him a sought after speaker in the areas of lending, collections, and sales. Bruce has served in several capacities, including: C.O.O. for a 1.5 Billion Credit Union, the VP of lending for two other large credit unions; the director of collections; a lender in two banks and a savings and loan; a lending professional with one of the nation s top credit union audit firms; and an expert witness in loan fraud and bond claim cases. Bruce has been a frequent presenter at conferences around the country for 20+ years. He attended the University of Nevada in Reno and earned a Retail Banking Diploma from the American Institute of Banking. 1

2 First: It is strongly recommended that Credit Unions either considering implementing business loans or that already have implemented a business loan program review NCUA Rule 723 to ensure that the business loan program is compliant with all aspects of Rules, Regulations and Restrictions. OVERVIEW 2

3 Implementing and operating a business loan program is a challenging process. Business loan programs have many compliance requirements including NCUA Regulatory requirements. Consideration of resources, knowledge, and expertise of staff. The key element of any business loan program is the ongoing monitoring of the operations of the business loan program. Management s role: Oversight Oversight Oversight 3

4 Generally, business loans have a far greater loan balance than consumer loans. The potential loss being greater requires thorough and clear Business Loan Policies and Procedures as well as effective due diligence. One of the most significant risks in business lending is the risk of failure to perform adequate due diligence both at the time of the business loan s inception and during the required ongoing monitoring and analysis of business loans. 4

5 KEY BUSINESS LENDING CRITERIA Coupled with the above is a potential lack of understanding of the nature of business lending and how it differs from consumer and all other forms of lending. When a consumer loan is booked, it is time to go on to the next loan. When a business loan is booked, the work is just beginning for that loan and the work does not stop for that loan until the business loan is paid off. Generally, underwriting a business loan includes the same considerations as any other type of loan: Capacity, collateral, credit history, character, capital/condition (net worth) Documentation and verification Consideration of all factors, etc. 5

6 But, business loans require: A more detailed and understanding of the business, the borrower(s)/guarantor(s) and how the business operates. A higher degree of understanding of business (and personal) financial statements and how to analyze financial statements. Ongoing (at least annual) review of the business financial statements. Effective oversight of all of the above. As with any other type of loan, there are many underwriting considerations for business loans. However, we are not going to discuss all of the underwriting criteria for business loans during this session. 6

7 Todays session will focus on KEY underwriting criteria for business loans that must be reviewed and monitored on an ongoing basis in a business loan program including, but not limited to: Business financial statement analysis. Risk rating the business including the estimated/potential loss for the business within defined risk rating tiers/standards. Use of a Watch List. Debt Service Coverage ratio including both the Debt Service Coverage ratio (DSCR) of the business and the global DSCR of the business and borrowers and how these should be documented. 7

8 (Continued) Performance of site visits. Annual review narratives and recommendations for every business loan. Understanding salability/desirability, how these conditions affect a business loan in the event of foreclosure and how to document consideration of these factors in the business loan file. All of the above criteria must be fully documented in the loan file by the business loan officer approving/denying the business loan. Management needs to be able to see how this was accomplished to determine the adequacy of the documentation. Management needs to monitor these criteria for each business loan on an ongoing basis 8

9 For all business loans, the need to understand the reasonableness of the capacity of the business (and guarantors) to be able to repay the loan is one, if not the most, important considerations for determining whether the business loan should have been granted or not. Management must be able to review the business loan and to see how the capacity of the business was determined before and after loan origination to enable the effective ongoing review and monitoring of the business loan. This requires clear documentation of the cashflow of the business and the capacity of the business to service the debts including the business loan. Documentation of this should include a multiyear financial statement analysis comprised of many component parts and a clear and concise narrative of the business. 9

10 In addition: Most business loans granted by credit unions are secured by collateral and clear documentation of the adequacy of the valuation of the collateral for the business loan becomes a primary consideration in the underwriting and ongoing monitoring of the business loan. Business/commercial property appraisals are complex and need thorough understanding. Appraised value is not enough: Value can be affected by salability/desirability. A significant tool for assisting with documenting the nature of the business, the stability of the business, the valuation of the collateral and the prospective desirability and salability of the business is the use of site visits. Go visit the business in person. Ask to see how the business operates. Look at the processes of the business. Site visits once, twice, three times per year. Document all site visits. 10

11 Use of a site visit checklist form is recommended to ensure that key components of the site visit are adequately documented for the business loan file. Use of a site visit checklist also serves as a fundamental part of the loan officer s narrative of the reasons to approve/deny the business loan and/or the ongoing factors that affect the risk rating of the business loan. Site visits are an important part of the ongoing monitoring of any business loan by giving management a hands on view into the current and ongoing condition of the business both financially and physically (the property), Site visits should be a requirement of both the origination of the business loan and the ongoing periodic review of the business loan. 11

12 Salability and desirability of the collateral is an important factor in any business loan consideration. Credit Unions need to determine what types of collateral that can be accepted for business loans. Salability and desirability of business loan collateral, generally business property, should have a direct effect on the types of business loans the Credit Union will offer and the types of collateral that will be accepted. Understanding the ease or difficulty of disposing of business properties in the event of foreclosure is an essential part of any business loan program. For example: Business loans secured by church property could have a low LTV but, in the event of a foreclosure, church property can be very difficult to sell and desirability of the collateral is an important factor in any business loan consideration. 12

13 Consumer real estate loans are a very different matter homes are generally always able to sell. Though there must be the right buyer, right buyers are more plentiful for homes. Business loan properties are more unique and require the right set of circumstances to be able to sell and the right buyer may be far less plentiful making it more difficult to sell foreclosed business properties and generally resulting in greater potential loss to the Credit Union. Documenting the salability and desirability of business properties in the event of foreclosure is an essential part of any business loan monitoring process. Business loans located in unusual areas of town, undeveloped property, property with geographic or economic problems may have low LTV s causing the intrinsic desirability of the property to be low which negatively impacts the ability to dispose of the property in the event of a foreclosure. 13

14 KEY BUSINESS LENDING CRITERIA For example: A ski resort: Seasonal income, subject to climatic conditions, can be difficult for customers to get to. An office building in an area where there are many other office buildings and all of the office buildings in the area, including the office building for the proposed loan, have historically high vacancy or low occupancy. The above are just a few examples of how salability and desirability affect business loans but it emphasizes that monitoring these criteria is an essential piece of the ongoing oversight process for all business loans. 14

15 Effective monitoring and oversight of business loans requires that key elements of the underwriting of the business loan are adequately documented in the business loan file both at loan origination and at the periodic review phases of each business loan. 5 KEY CRITERIA OF MONITORING 15

16 CRITERIA FOR BUSINESS LOANS For this session there are five key criteria that must be monitored at loan origination AND ongoing during the life of each business loan: 1. Business financial statement analysis and the debt service coverage capability of the business and guarantors. 2. Valuation of the collateral for the business loan. 3. Risk rating the business loan. 4. Utilization of a watch list for business loans. 5. Monitoring processes for business loans. 1 BUSINESS FIANANCIAL STATEMENT ANALYSIS INCLUDING DEBT SERVICE COVERAGE CAPABILITY (see handout) 16

17 Ongoing monitoring and oversight of any business loan must include a detail review of the financial condition of the business including verification that the loan officer performed an adequate consideration of the financial capability of the business to service the debt/loan at loan origination and ongoing during the periodic reviews of business loans. The use of an effective business loan financial statement analysis work sheet will facilitate the oversight of this. At a minimum, the financial statement analysis should detail: The financial condition of the business and borrowers including the debt to equity ratio and amount of working capital. The income of the business and borrower(s) to service the debt/loan. (Current and over time 2 or more years) Documentation of the Debt Service Coverage Ratio, including the global DSCR. The loan officer s conclusion as to the stability of the business and the ability of the business (and borrowers) to service the debt. (Including trend considerations) 17

18 Debt Service Coverage Ratio (DSCR) The Debt Service Coverage ratio (DSCR) is arguably the most important business loan ratio. The debt service coverage ratio for a business functions may appear to be similar to the debt to income ratio for a consumer but it is analyzed very differently. Generally, the DSCR must exceed 1.00%. The DSCR must exceed 1.00% to ensure that the business is making a profit and that the business can increase capital. 18

19 KEY BUSINESS LENDING CRITERIA FINANCIAL STATEMENT ANALYSIS Debt Service Coverage Ratios (DSCR) over 1.00% (example: 1.20%, etc.) indicate positive cash flow for the business and positive net profit for the business in excess of the costs for the business. This holds also holds true for the Global DSCR (which includes the borrower(s)/guarantors numbers). Positive residual cash to service debts that are multiples of the debt expense are also strong. The business loan officer should have these factors clearly documented on the Financial Statement Analysis Worksheet and the business loan narrative concisely. Other Business Loan Ratios (see handout) 19

20 Part of the analysis of the financial condition of a business loan is consideration of a number of other business ratios and can assist with the loan officer s conclusion as to the stability of the business and the ability of the business (and borrowers) to service the debt. Determine what business ratios apply to the specific business and document the ratios in the file. 2 VALUING BUSINESS LOAN COLLATERAL 20

21 Oversight of the valuation of the valuation of the collateral for business loans is the verification that: The appraisal is a commercial property type appraisal performed by a commercial property appraiser. Documentation of the adequacy of the appraisal. Recency of all appraisals used. (Credit Union standard) Documentation of the discounting of appraised values to reflect desirability and salability. 3 Risk Rating Business Loans (see Risk Rating Criteria Handout) 21

22 Risk Rating business loans is an essential part of monitoring the stability of the business loan and the possibility that the business loan might become a problem consideration up to and including potential loss. The risk rating of a business loans is performed at: Business loan origination Ongoing: At least annually during the annual review or anytime the Credit Union determines any factor that could affect the business loan. Oversight of business loans should verify that risk ratings are being performed and the adequacy of the risk ratings assigned to each business loan. 22

23 Risk rating criteria are generally divided into 8 tiers or 8 levels of risk rating. The 8 tier risk rating format is generally used throughout commercial banks and other commercial lenders. There can be other risk rating formats but great care should be exercised so as not to affect the timing of the recognition of any risk condition that could affect the classification of a business loan for potential loss. 23

24 Note: The formatting of risk criteria into a series of risk tier levels accomplishes this but the risk rating criteria is only as effective as the analysis of risk performed. Risk rating tiers/levels: 1. Excellent 2. Strong 3. Satisfactory 4. Watch 5. Special Mention 6. Substandard 7. Doubtful 8. Loss 24

25 Both the number (1 through 8) and the term (Excellent, Substandard, etc.) are used as part of the risk rating classification process for each business loan. The criteria that each risk rating tier is comprised of is generally judgmental and are used as a benchmark for the classification of business loans for the potential risk present in the loan at a specific moment in time. Note: The criteria used to determine the risk rating tiers should be periodically reviewed and reevaluated for adequacy. The oversight process should verify that this reevaluation of the criteria for each tier is being performed. 25

26 The monitoring and oversight process should verify that the process for risk rating business loans: Has established guidelines (risk criteria) to follow for each risk rating tier. Are thoroughly objective in the consideration of the risk criteria for each business loan. Full documentation of how the risk rating was determined. ( A worksheet can assist) 4 WATCH LIST (see example watch list handout) 26

27 The Watch List is utilized to track and monitor the Credit Union s risk classification of each business loan. The Watch List is completed on a regular basis (monthly). The Watch List assists management with monitoring the potential risk of loss within the business loan portfolio. The Watch List should be a part of the Credit Union s ALLL calculation process. The key sections of the watch list are: The Risk Rating assigned to each loan. The migration of risk ratings. (Comparing the previous period risk rating for a business loan to the current risk rating for that loan.) Loan Officer s notes/explanation for the risk rating assigned to the business loan. The estimate of potential loss for the business loan. 27

28 The oversight process must ensure that the risk ratings and estimates of potential loss are being determined objectively. The Credit Union should have a process in place that reviews how the risk ratings and estimates of potential loss were determined to verify the objectivity and adequacy of the application of risk factors. The migration of the risk ratings of business loans is often not adequately monitored: Documenting risk rating migration enables improving and deteriorating trends of the business loan to be better tracked and monitored. Documentation of the migration of risk ratings for a business loans serves as an early warning mechanism that a business loan is having problems. The migration of risk ratings causes estimated loss potential to be more adequately/timely recognized. 28

29 The Watch List should be periodically reviewed by senior management. Consider having the risk ratings periodically independently tested/audited to ensure compliance and adequacy. (Independent of the loan department preferred) This will give the Credit Union some assurance as to the adequacy of the potential loss present in the business lending portfolio and the adequacy of the business loan department s considerations of potential loss for business loans. 5 Monitoring Processes for Business Loans 29

30 For this session, we do not have the time to cover all possible tools for monitoring business loans. However, some of the key considerations and processes for the oversight and monitoring of business loans are discussed below. Special reports that document anomalies to Business loans. (Interest rates, paid ahead, due dates, delinquency, etc.) Special reports that monitor business loan performance including delinquency and loss. Required periodic reevaluation of the criteria for each of the risk rating tiers. Senior management review of the Watch List. Ensuring that the NCUA required periodic review (annual) for each business loan is being performed in a timely manner and that the Credit Union has a mechanism and report in place that monitors business loan review date exceptions. The use of checklists of required business loan documentation. (see handout) 30

31 Periodic review of the performance of each business loan and comparing that performance to the risk rating/classification/watch List criteria for that loan. Self audit of business loans for compliance by the Credit Union s internal audit function. Tickler tools have been adequately implemented to ensure that ongoing annual review is performed. Possibility of a special consulting engagement or other type of review of the business loan program and portfolio by a third party. At the end of the day, the more monitoring mechanisms that are incorporated in the Credit Union s business loan program, the better the Credit Union will be positioned to: Note any negative or adverse conditions in the business lending portfolio and make necessary adjustments to prevent or mitigate potential loss. Ensure compliance with Credit Union business loan Policy and Procedures and NCUA Rules and Regulations for business lending. 31

32 Some important questions to ask about how you are monitoring your business loan program: How is the adequacy of the minimum DCSR (Debt Service Coverage Ratio) that is acceptable to the Credit Union being periodically reevaluated? Is it being reevaluated? What are the minimum acceptable DSCR s? The adequacy of LTV maximums. Are all of the criteria for each risk rating tier adequate? Do they need to be modified? 32

33 What is the Credit Union s business loan detail file review process and who performs this review? How is this monitored and reported? Does the Credit Union have an audit function available to perform detail business loan file reviews for the adequacy of documentation, compliance with Credit Union Business Loan Policies and compliance with applicable Rules and Regulations (NCUA, etc.) Is a Watch List being employed and who reviews the Watch List? Is the condition of the business loan portfolio being regularly reported to the Board, including all business loans classified as special mention or worse, and how is this being reported to the Board? 33

34 FINAL THOUGHTS It is recommend that everything discussed in this session be included and defined in the Credit Union s written Business Loan Policy and/or Business Loan Procedures document(s). 34

35 There are two more handouts: 1. A table describing types of business entities. 2. Example of a basic business loan required documentation checklist. QUESTIONS? 35

36 THANK YOU! Contact Information Bruce Hull Consultant, Lending and Collections Specialist Team Resources Tucson, Arizona Office: Fax: Phone:

37 KEY BUSINESS LENDING CRITERIA TTS CUWebinars.com Upcoming CUWebinars April 18 th - Credit Reports and Credit Scores April 26 th - Beyond Time Management: The Clock is Not the Enemy May 6 th - Motivating & Managing the Front Line May 9 th - Opening Formal and Informal Trust Accounts May 25 th - Cybersecurity Exams June 3 rd - Onboarding Your New Hire June 9 th - 10 Critical Issues on Opening Limited Liability Companies Don t forget about our listing of OnDemand programs at CUWebinars.com! 37