Basics of Commercial Loan Analysis

The current economic climate presents both problems and opportunities for credit unions to improve and adjust how they assess credit risk.

Isn’t this an exciting moment to be a credit analyst? The need for credit analysis and credit risk has never been more apparent in the past year. With so many complexities and changes in commercial credit analysis today, it’s critical for those just starting in their careers as credit analysts to lay a firm foundation to prepare for such changes.

Credit analysis best practices are vital to guaranteeing safe and sound lending procedures. Thus all credit analysts must have a clear grip on them, from comprehending and assigning credit risk to evaluating and making credit choices.

Credit Risk

Interest rate, liquidity, and credit risk are three critical sources of inherent risk that all financial firms confront. While these categories of risk are intertwined, credit analysts are primarily concerned with credit risk, which is the duty to repay depositors regardless of whether or not loans are returned.

Essentially, we’ll take people’s money and invest it or lend it to other members in the form of loans, hoping that those we lend it to will repay us so that when the depositor needs to withdraw their money, it’ll be there.

Credit analysts want to ensure that the loans their credit union makes are safe. Credit analysts achieve this by assigning credit risk to a loan using loan classification and credit grading methods. The following three characteristics should be considered while grading a loan:

  • It should identify loans with potential credit issues as soon as possible.
  • It should grade or categorize loans effectively, particularly those with well-defined credit flaws that risk payback so that prompt action may be taken and credit losses can be reduced.
  • It should provide accurate and timely credit quality information to management for financial and regulatory reporting purposes, including assessing an adequate loan and lease loss reserve (ALLL).

It might be difficult for rookie credit analysts to distinguish between loan grading and underwriting. The distinction between the two comes down to the timing of the analysis. If the loan has not yet been issued, the phrase underwriting is usually used. As a credit analyst, you can still apply covenants and change terms and pricing to account for the risk. On the other hand, loan grading occurs after the loan has been entered into your accounting system. Credit analysts can continue to assign risk using the same risk rating matrix or model, but they have fewer choices for mitigating credit risk.

Credit Risk Assigning

To properly reflect commercial credit risk when assigning credit risk using a loan grading system, the risk scoring matrix should contain objective analysis, comparative analysis, and subjective analysis.

Consider how wide and how many points to provide in the loan grading scale itself. If you have too few, credit analysts will likely undervalue riskier loans; if you have too many, you will begin to see declining profits. A numeric eight- to nine-point scale, which allows analysts enough dispersion of the loan portfolio, is something I regularly advocate. When each loan in the portfolio is mapped out, the loan grading scale should appear like a bell curve, with most loans falling into buckets three and four.

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Taking a look at the 5 Cs of Credit

The five traditional credit Cs are at the heart of credit analysis: capacity, capital, circumstances, collateral, and character. Capacity – determining a borrower’s ability to repay a loan by comparing predicted income flow to the recurring debt the borrower is accountable for – is the most important of the Cs, in my opinion. Most credit unions will employ a DSCR or debt-to-income (DTI) ratio to analyze a member’s ability to repay the loan to understand cash flow. The following are the additional components:

  • Capital refers to a down payment or the amount of money a borrower has available to contribute toward a loan. The bigger the down payment, the less likely a borrower will default on a loan.
  • Conditions: Traditionally, conditions have indicated the loan’s terms, such as the principal balance, payment terms, and interest rate.
  • Collateral: Collateral serves as “insurance” for the lender if the borrower defaults, allowing the lender to recuperate any potential losses.
  • Character: It’s tough to quantify character, especially in a thriving economy. Credit unions frequently use FICO credit ratings to analyze a borrower’s character.

When you’re looking at a member seeking a loan in 2021, you should be asking yourself: how has the pandemic affected or changed this borrower’s income or cash flow? Has the member’s industry been adversely impacted, such as a bar or restaurant with limited capacity? The epidemic has affected the debit side of the balance sheet and members’ financial situation. Have stimulus payments or Paycheck Protection Program (PPP) loans influenced the borrower? What happens if the member isn’t paid promptly? While the five Cs will always be necessary for analyzing credit risk, credit analysts should pay special attention to two additional Cs in this environment: coronavirus and cash position.

Creating Credit Memorandums

Credit memos are one of the most challenging components of credit union credit analysis to grasp, but they are also one of the most crucial papers in the loan’s life cycle. The loan committee will use credit memoranda to determine whether or not to approve the loan. The lender will want to present a thorough picture of the borrower in the interest of risk management at the credit union. Credit notes should be utilized consistently across industries, loan amounts, review types (new, renewal), and loan types; however, different templates can be used. While the credit union may use several templates, they should all have the same features to guarantee consistency and allow board members to check for crucial things to make decisions quickly. Consider the following best practices to present enough information for lending committee members to decide without overwhelming them with details:

  • In the credit memo, include an executive summary (no more than two pages);
  • Have an overview of the members and a final lending recommendation.
  • Compile a summary of the risk score, terms, pricing, and any covenants that may apply.
  • Emphasize crucial financial figures and statistics;
  • Include a summary of the industry;
  • Identify any loan policy exceptions; and
  • Provide extra supporting documentation, such as global cash flows (if the member owns numerous businesses), guarantor analysis, collateral analysis, additional member products and account information, and the member’s business plan.

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