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Originating New Loans During COVID-19: Character Risks That Credit Analysts Must Consider Before Rec

With the economic fallout related to COVID-19, loan demand may be soft. Businesses have taken PPP loans and filed for forgiveness. The Federal Reserve has lowered the threshold for the Main Street Lending Program to $100,000 to attract smaller businesses. However, not all parts of the economy are suffering and some businesses may still qualify for C&I or CRE loans.

If new loan prospects find their way into your institution, their valid loan request will find its way to one of your credit analysts to assemble the borrower’s information for the loan committee to consider. Credit analysts must focus on the Five C’s: Character, Capacity, Capital, Conditions, and Collateral. In good times, character is the most important of the Five C’s.

However, in difficult economic times, character can be put to the test. That is why it is critical to have the credit analyst focus on character, especially for a loan request from a borrower that is hoping to establish a new relationship with your institution. Maybe they are looking to refinance as part of a disputed workout with another lender. Or they may be asking for working capital to serve as a buffer for possible revenue fluctuations that they easily handled internally before the pandemic. Whatever the reason for the loan request, a character analysis is an important first step for the credit analyst.

Indications of Character and/or Management Weaknesses

When evaluating available financial information, credit analysts must answer questions that may indicate actual or potential character weaknesses. Here are some examples of character related questions that the credit analyst can consider:

1. Is the potential borrower honest?

The following may be indicators of dishonesty:

  • For borrowers with an existing banking relationship with the institution, look for inconsistencies between current and past information in the application. For instance, check the credit files for older financials and compare them to the current financial filed with the application. Do the current financials look significantly better than the older financials and if so, is the reason for the improvement plausible or does the improvement raise a red flag?

  • For both existing or new borrowers, check for inconsistencies between financial reports submitted to the institution and information the lender obtained through site visits or interviews. Do the inconsistencies raise a red flag that could reflect on the borrower’s honesty?

If investigations show that the borrower purposely provided erroneous, misleading, fraudulent, or deceptive information, then the borrower's character is clearly unacceptable.

2. Is the potential borrower financially conservative or prone to taking excessive risks?

While it is impossible to define any single measure of prudence or risk taking, credit analysts can assess the borrower’s risk appetite through analyzing available information. For example:

  • Does the borrower’s personal financial statement show more than a minimum of liquid investments and bank deposits?

  • Does the individual or the business he or she owns or manages hold speculative investments?

  • Does the business undertake major expansions in unproven new products or new markets?

  • Are there signs that sales are growing faster than management and production activities can support?

  • Does the individual or the business he or she owns or manages carry key man life insurance?

  • Is the amount of cash on hand adequate for emergencies and unforeseen developments?

3. Does the owner or manager make sure that the business pays its creditors according to the terms required by those creditors?

Credit analysts should review accounts payable agings if the total liability for accounts payable is large relative to the quantity of the cost of goods sold. Often, a business that pays its vendors slowly is either experiencing a liquidity problem or risking one. In addition, owners or managers willing to violate repayment terms with suppliers may be equally willing to violate terms required by the institution.

4. Do the potential borrower and the business he or she owns or manages keep accurate and thorough records?

Often people who are careless with their record keeping are equally careless with their investments and obligations.

To learn more about the Five C’s of credit analysis, click here. Also, click here to learn how to be certified in the commercial credit analysis process.

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