The ongoing U.S. economic recovery and continued tight lending conditions make it important to evaluate the credit risk in various relationships. A financial institution’s first defense against excessive credit risk is the initial credit-granting process, which includes sound underwriting, an efficient and balanced approval process and a competent lending staff.
Three Ps of Credit Analysis
These concepts are summarized in the three Ps of credit analysis: policy, process and people. Policy (or procedure) refers to a particular way in which something is completed.
Loan policies provide a framework for the institution’s lending activities. They set the standards for portfolio composition, individual credit decisions, fair lending and compliance management. Generally they will be supplemented by more granular underwriting standards, guidelines and procedures.
For financial institutions, loan processes assign accountability and establish the responsibilities of people involved. For example, a process will identify who is authorized to approve a covenant violation or who arbitrates risk rating differences.
People, of course, refers to the individuals executing the process, including their appropriate recruitment, training, available tools and ongoing management.
Within each of these Ps, it is critical for a financial institution to adequately address and uphold credit standards. The three Ps outline the lending function at an institution and must be filled in with prudent, risk-mitigating standards.
The Five Cs of Credit
Credit analysis standards should start with properly examining the ability of a potential borrower to repay a loan. The objective is to determine whether the borrower has the ability and willingness to meet its financial obligations as they come due.
Effective loan portfolio management begins with oversight of risk in individual loans, at both origination and review, and the quality of individual loans can be assessed using the five Cs of credit.
1. Capacity: This factor measures a borrower’s ability to repay a loan by comparing income to recurring debts. Analysts should principally be asking, “Can the borrower generate adequate cash to repay the loan?”
2. Capital: With this factor, the analyst tries to assess the net worth or equity of a business. Is the borrower adequately capitalized (within industry standards) to withstand unexpected loss?
3. Conditions: The three Ps should also incorporate an analysis of conditions, which characterize the economic, industry and market environment. These conditions can and will change. When they do, is the borrower flexible enough to adapt?
4. Collateral: Credit analysis should also include a close look at collateral, estimating the collateral available to secure the debt. The primary consideration is will there be an alternative source of repayment if the primary source fails.
5. Character: Finally, a complete risk assessment will also review the personal integrity or character of business owners and guarantors. This will help analysts gauge if the borrower’s management would be willing to repay the loan — and would management attempt to do so under adverse conditions?
Chuck Nwokocha is a senior risk management consultant at Sageworks, Raleigh, N.C. (www.sageworks.com)
Copyright (c) November 2013 by BankNews Media