Master Class: Credit Process: The Credit Decision
We have now seen a reasonable amount of information on Willy Whale Inc, our friendly, next-door stuffed toys manufacturers and distributor. A credit memorandum using the same information has been prepared and presented before the loan committee. It is now time to take a decision.
A credit decision is a composite of three interlinked decisions
- To lend or not to lend – Accept / Reject
- Terms at which the bank should or is willing to lend – Covenants or Term Sheet
- The interest rate on the loan – Loan Pricing
Accept / Reject
There are a number of factors that go into the accept / reject decision. A bank’s relationship with a customer, the customer’s credit history, track record, profile, future outlook and management team are big factors. We will come back to these in the session on credit decisions. The decision to approve loan lies either with the concerned loan officer or with a Loan Committee (varies from institution to institution). The loan committee comprises of a number of people (between three & ten). The loan officer responsible for investigating the case presents his findings and recommendations to the loan committee. The underlying idea is that opinions and perceptions of people differ and they provide a broader perspective on the lending decision.
Most lenders have a very well defined hierarchy that drives authority, responsibility and approval limits across the lending function. As loan amounts move to higher levels, the number of people involved in making the decision also increases. Loans above a certain size (expressed as a % of bank’s capital) can only be approved by the Board of Directors.
The design and structure of the term sheet is dependent on how strongly the bank feels about the overall credit profile of its customer. Term sheets are a function of the risk management, loan monitoring and diversification policies of a bank. These are stipulations that the borrower promises to abide by that are designed to protect the rights and interests of a lender. Covenants can be of three types:
- Negative – where the borrower is asked not to do certain things, i.e., restrictions are placed on the borrower. The lender may prevent the borrower from taking on additional debt until the term of this loan expires. Or the borrower may be asked to refrain from selling certain assets. Limitations may also be placed on payment of dividends or stock repurchases by the firm. These limitations, however, must be realistic and should be designed to work with the interests of both parties.
- Affirmative – where the borrower agrees to fulfill certain duties and perform certain actions. For example, the borrower has to agree to make interest and principal payments, give periodic and timely financial information (e.g. when a borrower pledges inventory at the time of taking the loan, the lender may ask for periodic inventory reports to assess its value)
- Financial - where the borrower agrees to meet certain financial requirements over the term of the loan. For example, the lender may ask the business to maintain certain profitability, leverage and liquidity levels.
The interest rate charged on a loan is a function of competitive pressures, market factors, customer’s credit ranking, relationships & the bank’s strategic positioning (conservative, moderate, aggressive). A well-defined & objective loan pricing process ensures that a lender stays within the risk & earnings profile approved by the board of directors. However more often than not, competitive pressures will drive rates below targeted yields and risk profile.
Concept Title: Compliance & Documentation
In litigations it’s the side with the best documentation that wins. Documentation is the most important and crucial part of the lending process. This is where a bank establishes a claim on the customer’s assets in case of default. It also establishes if the bank’s loan is senior or subordinate to other loans. Subordination and seniority define when a creditor will be repaid in case the business goes bankrupt. If the lending documentation is inaccurate or non-compliant the claim can be invalidated. An invalidated claim leaves a bank with no recourse to the collateral securing the loan.
However documenting or establishing a claim is not enough. There are a number of internal, external, industry and regulatory agencies that regulate & review the lending process. A lender also has to document compliance with the best practices, checklists & guidelines established by these organizations. The terms and conditions of the loan remain negotiable through out the life of the loan. Six months later a borrower may find that there certain covenants are affecting operations of the firm negatively. Lenders do allow relaxations in the terms, especially if the borrower provides strong and realistic reasons. Documentation therefore needs to remain current with changes in the loan structure, business environment, market conditions and relationships.
When does documentation and compliance start? In well managed banks it starts with the point of contact between a customer and a lending officer. It goes on throughout the one to eight week duration of the credit process. It peaks when additional documentation is prepared and filed after the term sheet is presented and approved by the loan committee and the customer.
The terms and conditions of the loan remain negotiable throughout the life of the loan. Six months later a borrower may find that there certain covenants are affecting operations of the firm negatively. Lenders do allow relaxations in the terms, especially if the borrower provides strong and realistic reasons.