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9 C's of Credit


July 9, 2010

By: Larry W. Martin

We all know the five key elements ( 5 C's of credit ) to consider on a credit request: character, capacity, capital, collateral, and conditions.

Some of Bank Strategies LLC's work is with banks experiencing asset quality issues.  We have found four additional C's are often significant contributors to a bank's asset quality condition.  The four additional C's are: Culture, Compensation, Competency, and Closeness.  When these four elements become misaligned problems usually develop.

Culture - A primary focus on asset and loan growth and profit characterize the lending culture of banks with asset quality issues.  Success indicators, communications and rewards recognize the growth and profit achievements.  This culture often leads to credit administration and other risk management practices becoming secondary considerations.  The growth culture can also blind the bank to outside environmental changes and their potential impact on loan quality.  Collectively, the blind spots have the potential to substantially impact the next regulatory examination with loan downgrades, insufficient ALLL levels, restatement of earnings, and significant criticisms.  There is nothing wrong with a focus on growth and profit, but it must be balanced with strong risk management practices and a pragmatic view of the markets served.  

Compensation - Incentive or bonus compensation tied to loan production can lead lenders, loan committees, and Boards to approving loans they normally would not.  In one bank, we found an extreme example where a loan went to committee four times before the lender either convinced the committee of the soundness of the loan, or the committee gave in to the loan officer's persistence.  When we were at the bank the loan had been classified and was going to represent a substantial loss.  In another case, the loan committee was comprised of lenders who all participated in the loan production incentive system.  "You approve my loan and I will vote for approval for your loan", was the operating approach.  To achieve long-term success a bank must have balance in compensation between bottom-line results and asset quality.  Loan approval groups must have an asset quality mission that trumps new loan volume consideration.

Competency - We recently saw a loan write up for a new $1 million line of credit that was two paragraphs, four sentences long with virtually no financial analysis of the borrower.  This casual presentation approach was standard practice for the lender who was consider a star producer. This begs many questions.  Why was the lender allowed to present such an inadequate presentation?  Why did the loan committee approve the deal as presented?  When we were in the bank, the loan was classified.  There are too many lenders possessing insufficient underwriting skills to properly analyze a credit and then adequately prepare a written loan presentation so others can fully understand the credit.  And, we have bank management that allow these conditions to exist without providing necessary support to mitigate weaknesses and to ensure organizational consistency in loan presentations.

Closeness - Lenders originate credits when they believe in the loan purpose and the ability for repayment.  The lender believes in the borrower and tend to know the borrower well, they are close to the borrower.  The closeness to the borrower can become a problem when the loan begins to have issues, the lender being close to the customer still believes in the borrower and is an advocate for the borrower.  The examiners look at the loan, guess what?  They downgrade it since it is not performing per the original terms of the loan.  The loan officer is outraged and prepares a problem loan report that states, "The regulators downgraded this credit since it is a CRE credit even though all payments are current."  The payments were being made from the borrower’s personal IRA funds, not as originally defined in the loan, and the IRA funds were ending.  The example just given is an actual situation.  As a lender, you want to be close to customers, but you must be pragmatic in your view of the loan and the situation.  You must wear two hats, the customer advocate hat, and the bank asset quality hat, and at some point, on a problem credit you must take the customer advocate hat off completely.

We hope these other 4 C's are not issues with you and your bank.  If they are, you need to address them quickly.  Conducting a third-party environmental study can help assess your situation and needed improvements.

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EMail: Jim@bankstrategiesllc.com