By Jim Devine
More than 2,000 credit unions now offer member business loans for a total dollar volume of more than $20 billion. Most of these CUs initiated their MBL activities during the last five years.
For the most part, the CU industry has experienced very little difficulty with the performance of their business loan portfolios. However, many existing loans were booked during a relatively healthy economic period, where the majority of small businesses were performing reasonably well.
So have credit unions really been that good at member business loan underwriting and credit administration? Or have they simply been in the proverbial right place at the right time?
CUs will soon find out how good their initial business loan underwriting efforts have been and whether they truly possess the expertise to manage business credit risk in this very challenging economic environment. It will be imperative for CUs to monitor the operating performance of their small business borrowers to make sure they are maintaining a risk profile consistent with the CU's expectations.
A good business credit risk management system begins with a thorough and consistent approach to the underwriting process. Before approving a given loan request, a business lender must understand that particular small business—and the chemistry of its business model.
As part of this risk assessment process, the lender must be able to identify the critical cash determinants associated with this business. The lender must also clearly identify both the primary and secondary sources of repayment, along with any other business model issues critical to the going-concern performance of the business.
Lending policies should specifically identify how debt service coverage is measured. Most policy manuals describe a minimum coverage ratio in the $1.10-1.25-to-$1.00 range--in other words, the lender wants to see at least $1.10 in capacity to pay for every $1.00 of debt repayment required. But there are different ways to measure capacity to repay. All staff members involved in the member business lending effort should consistently use the same definition of debt service coverage in their underwriting efforts. Jumping around can create real challenges in trying to manage risk from an overall loan portfolio perspective. For this same reason, everyone in the lending foodchain should understand how to measure operating cash flow.
Once the underwriting process has determined that the prospective borrower's operating risk profile meets the CU's standards, the CU can move forward and approve the loan.
Now the real fun begins! In reality, the credit risks begin once the CU has approved and booked the loan.
The truth in lending is that last year's performance does not pay back the business loan you booked today. Future performance will ultimately dictate repayment capability.
Given this scenario, CUs must be in a position to monitor the ongoing performance of their business borrowers, compared to anticipated or expected levels of operating performance.
Good business credit administration processes are built on business model structure expertise. The process should be able to stress test critical cash determinants and detect any deterioration in a borrower's operating performance—in a timely manner.
The objective is to keep the risk profile of the borrower at or below the level that existed when the loan was originally approved. To continually monitor risk levels, CUs must develop and use a business loan risk-rating system.
If a borrower's risk profile increases beyond the profile in place when the loan was approved, the lender must be capable of taking action to address the reasons for the deterioration. The lender must also be able to modify the working relation with the borrower to accommodate the change in the risk profile.
The deteriorating condition of the national economy is inevitably going to put performance pressures on small businesses. CUs are starting to experience their first real challenges with non-performing small business loans. Senior management and MBL officers of every CU engaged in MBL must regularly reassess the condition of their MBL portfolios, as well as their business loan policies and procedures. The goal is to position the CU to appropriately manage business portfolio risks on an ongoing basis.
To deal with this risk management reality, CUs must make a commitment to continue developing their organization's business lending and credit administration skill sets. While many credit unions outsource business loan underwriting, regulators at both the state and federal levels have told the CUs in their jurisdiction that they are still ultimately responsible for making the final credit decision. They are also responsible for managing the loan on an ongoing basis while it is on their books.
Jim Devine is CEO of Hipereon Inc. and co-lead faculty of CUES' School of Business Lending.
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