Master Class: Credit Process: Mindset
There are four things that we want you to take away from this course.
2. Classification / underwriting
It’s all about the applicant’s intent – to pay back the loan. If the guy who walks in the door with a loan application doesn’t plan to pay you back, your sophisticated analysis is not going to work & the money is not coming back. How can you judge intent? Difficult question! Integrity helps, commitment helps, track record helps, collateral helps. These are very powerful indicators that can allow a loan officer to assess if there are enough incentives for the business and it owners to make the lender-borrower relationship work. To a large extent these four indicators are closely linked and feed off each other, we will come back to them again & again in the course.
Risks come in different shape and form and buyers of risks have different risk profiles. In order to benefit from dealing in a “risk” market, it is important for a buyer to understand the many dimensions of a certain type of risk as well as his own risk profile before agreeing to take on the risk.
The evaluation, classification and selection of a certain risk from a basket or pool of risks, is called underwriting. When a loan officer at a commercial bank, agrees to lend money to one customer from a pool of applicants, he effectively underwrites the loan. Similarly when Investment Banks offer to raise capital from public markets for their clients, they underwrite the public offering. Within an insurance setting an underwriter evaluates, classifies and selects risks that his company is willing to take. Although application and terminology may differ across industries the basic principles and objectives are the same. Its part art, part science, part instinct & part process. You must remember that there is a subjective as well as an objective side to a credit decision and the right balance needs to be maintained between the two.
|Commercial Banking||Loan Officer||Will repay loanWill not repay loan||Decision to offer loan & interest rate||12 months|
|Investment Banking||Investment Banker||Highly attractive public offeringUnattractive public offering||Decision to represent & fee structure||3 – 6 months|
|Insurance||Underwriter||Will not file a claimWill file a claim||Decision to offer coverage and price for coverage||12 – 120 months|
From a customer’s perspective, underwriting plays an important role on how a product is priced or offered. A loan officer’s assessment of financial prospects of a firm will determine if a credit line is extended and the interest rate charged on the line. Similarly an investment bank may decline to represent a client if required benchmarks for profitability, sustainability, viability and value are not met. Even if benchmarks are met, pricing for the offering would be dependent on the attractiveness of the issue. Finally in an insurance context, it is important that all insured pay a premium proportional to the risk they want their insurer to bear. In all of the above three cases, pricing is a function of classification
Classifications biggest contribution lies within the final decision-making. Even if a risk is classified and priced appropriately, the buyer of risk may decide to not take it on. Subjective factors, such as an organization’s culture, its competitive positioning (conservative, competitive, aggressive) and its strategic objectives exert considerable influence on the final decision taken. Each loan, each IPO prospect and each insurance policy is different from others and it may or may not fit the profile of the customer a loan officer, an investment banker or an insurance underwriter is willing to accept.