How Lenders Evaluate Credit Risk

Transcription

1 How Lenders Evaluate Credit Risk By understanding the needs and objectives of different lenders, you'll be better able to determine which source of financing is right for your business.

2 Contents 1. Inexpensive Capital Means Low Tolerance for Risk 2. How Lenders Evaluate Credit Risk 3. Underwriting Models 4. Pricing Models 5. Summary of Key Ideas 6. Become a Member

3 Inexpensive Capital Means Low Tolerance for Risk The relatively low cost of bank debt makes it a very popular form of financing. The hitch is that lenders in general, and banks in particular, can't tolerate much uncertainty. Because lenders' returns are typically limited to interest income, uncertainty translates into a risk of loss, and banks can ill afford to lose money on loans: The profit margin on a bank loan is razor thin. A 3% to 6% margin is pretty typical. Banks are highly leveraged. That is, they borrow money in the form of deposits in order to make loans to others. Leverage magnifies a bank's stockholders' returns when all goes well, but leverage also magnifies the effect of losses. Banks are highly regulated. In exchange for the benefit of FDIC deposit insurance which dramatically reduces banks' cost of funds and allows them to charge relatively low rates of interest banks must abide by restrictions imposed by Federal and state regulators. Banks' loss aversion combined with restrictions on their ability to price risk means that the availability of bank debt is constrained. According to the Federal Reserve Bank, only about 1/3 of businesses having annual revenues of less than $250,000 are able to receive "all or most" of their desired credit:

4 Some of that shortfall is being met through the emergence of non-bank alternative lenders who are using innovative credit evaluation (i.e. underwriting) techniques and who have fewer loan pricing restrictions (i.e. many charge 30% APR or more for their money).

5 How Lenders Evaluate Credit Risk A common framework for evaluating the risk of a loan is referred to as the 5 C's of Credit: collateral, capital, capacity, conditions, and character: The 5 C's of Credit These factors are, to a degree, substitutes for one another regarding their contribution to perceived credit quality. Strong collateral in the form of accounts receivable, for instance, might offset uncertainty regarding the borrower's ongoing debt repayment capacity (e.g. in the case of asset-based lenders).

6 Contributors to Perceived Credit Quality Collateral and capital are easily quantified and, therefore, readily available for formulaic credit evaluation. The evaluation of capacity through the modeling of past and anticipated future cash flows requires a bit more effort. Conditions and character are relatively subjective and less easily quantified. Relative Quantifiability of 5 C's of Credit

7 Underwriting Models Different lenders utilize different underwriting models. That is, they place differing emphasis on the various contributors to credit quality when deciding whether, and under what terms, to extend credit to a prospective borrower. Community banks are well-positioned to take all five credit factors into account. Local knowledge allows community bankers to incorporate positive assessments of character and local conditions into their credit evaluations. So even when there are perceived deficiencies in collateral and capacity, for instance, a community bank may be able to prudently judge a borrower to be creditworthy. However, with the continued consolidation in the banking industry, there are fewer community banks. So, new entrants such as Kiva and Able Lending have assumed the mantle of character-based lenders. Rather than having local bankers on staff who can know borrowers personally, the new generation of character-based lenders require validation in the form of a threshold amount of "friends and family" loan participation

8 before risking their own capital. In a sense, lenders such as Able Lending outsource the character-evaluation process in a manner that allows them to extend credit across the country without the cost of a national network of local bankers. As the term suggests, asset-based lenders tend to rely more heavily on collateral in their underwriting decisions. Factoring, for instance, is technically the sale of eligible accounts receivable to a third party at a discount to face value. In effect, the lender or "factor" might advance $0.80 today in anticipation of receiving $1.00 within 60 to 90 days. Asset-based lending is more broadly available than bank debt...but at a cost. Many marketplace lenders (e.g. Kabbage) use proprietary algorithms to make informed inferences regarding the 5 C's of credit. That is, big data and technology substitute for the judgement of an experienced lending officer. Analysis of the daily stream of credit card sales of an e-commerce retailer, for instance, measures capacity. When combined with a contract that anticipates daily collections to be applied toward the loan or advance, the "merchant cash advance" model operates in a manner very similar to accounts receivable financing.

9 Pricing Models All lenders ration and price risk. That is, they establish standards that set a limit on how much risk they will underwrite, and they charge a rate of interest within a range. The price charged on loans may be subject to state usury laws. Banks tend to have less flexibility regarding interest rates than do alternative lenders. As a consequence, banks ration credit more restrictively than do alternative lenders. However, bank debt tends to be a lot less expensive. Because more relationship-based alternative lenders such as Able Lending can more effectively take character into account when underwriting, they can make credit available to small businesses who can't yet access bank debt at a rate of interest that is lower than the rates charged by asset-based alternative lenders. Asset-based and Relationship-based Alternative Lenders

10 Summary of Key Ideas There are several types of lenders, each of which has a different tolerance for risk and can offer varying degrees of pricing flexibility. Pursuing a lender that is a mismatch with the characteristics and goals of your business can waste your time and money. Banks can typically offer the lowest rates of interest, but they also have the lowest tolerance for risk. That's one of the reasons that a consolidating banking industry continues to move away from the small end of the commercial loan market. Traditional and marketplace lenders who focus on asset-based loans make credit available to smaller, less established businesses, but the price can be very high. Innovative lenders such as Able Lending use a new twist on an old idea in order to make prudent character-based loans to small businesses at price that is somewhat higher than a bank loan but significantly lower than other alternative lenders.

11 Become a Member Dig deeper and engage in conversations with founders of other human scale businesses and other experts to help you achieve success on your terms. LEARN MORE