What a time to be a credit analyst, right? Throughout the past year, emphasis on credit analysis and credit risk has never felt so important. With so many nuances and changes occurring in commercial credit analysis today, it’s essential for those early in their credit analyst career to set a solid foundation to prepare for those changes. Strong credit analysis is critical to ensuring safe and sound lending practices, so it’s critical that all credit analysts have a firm grasp on credit analysis best practices, from understanding and assigning credit risk to analyzing and making credit decisions.
Commercial Credit Analysis 101: Back to Basics
March 3, 2021
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The basics of commercial credit analysis
Learn the foundations of credit analysis, including key data analysis strategies and best practices.
Takeaway 1
Understanding credit risk and assigning risk to loans is the foundation of credit analysis.
Takeaway 2
To determine creditworthiness, most analysts rely on the 5 Cs of Credit.
Takeaway 3
Credit memos can be one of the most difficult, yet important, documents to the life of the loan.
Setting the foundation
Understanding credit risk
Financial institutions face three key areas of inherent risk: interest rate risk, liquidity risk, and credit risk. While these areas of risk can be closely correlated with one another, credit analysts are primarily focused on credit risk, which is the obligation to pay back depositors regardless of whether loans are repaid.
“So, we’re going to take folks’ money and we’re going to lend it out, either by investments or through loans, and we’re hoping that those folks pay us back so that when the depositor wants to withdraw their funds, it’s there for them,” Rob Newberry, Senior Advisor at Abrigo, explained during a recent Abrigo webinar, The Basics of Commercial Credit Analysis.
Credit analysts want to ensure the bank is making good deals. To do so, credit analysts use loan classification and credit grading systems to effectively review a loan. Loan grading should include the following three attributes, according to Newberry:
- It should promptly identify loans with potential credit weakness.
- It should appropriately grade or adversely classify loans, especially those with well-defined credit weaknesses that jeopardize repayment so that timely action can be taken and credit losses can be minimized.
- It should provide management with accurate and timely credit quality information for financial and regulatory reporting purposes, including the determination of an appropriate allowance for loan and lease losses (ALLL).
For new credit analysts, it may be confusing discerning loan grading from underwriting and risk scoring. To clarify the difference, Newberry explains that it comes down to timing.
“If you haven’t done the loan yet, I kind of compare it to the horse being in the barn,” Newberry said. “You can still add covenants, you can change your pricing to account for some of that risk. Loan grading, on the other hand, is done after the loan is already on your balance sheet.”
Loan grading systems
Assigning credit risk
When assigning credit risk using a loan grading system, the risk scoring matrix should include objective analysis, comparative analysis, and subjective analysis to most accurately capture commercial credit risk. Quantitative factors may include debt service coverage ratio (DSCR) and loan-to-value (LTV) ratios, while qualitative factors may include management evaluation or an assessment of the strength of guarantors. Just over a third of webinar attendees (34%) responded that qualitative factors make up at least 50% of their scorecards and a fifth of respondents said their scorecards were almost entirely made up of quantitative factors.
As for the loan grading scale itself, consider how many categories are included in the matrix. Too few and credit analysts will likely miss risky loans; too many and an institution may find diminishing returns. Newberry recommends a numeric 8- to 9-point scale, which gives analysts enough dispersion of the loan portfolio. The wider loan grading scale should look like a bell curve when each loan is mapped out, with most loans falling in buckets three and four.
Gauging creditworthiness
Analyzing the 5 Cs of credit
At the core of credit analysis are the traditional five Cs of credit: capacity, capital, conditions, collateral, and character. Of the five elements, Newberry believes capacity – assessing the borrower’s ability to repay his or her loan by comparing expected income flow to the recurring debt the borrower is responsible for – is the most important of the five Cs. To understand income and cash flow, institutions will likely employ a DSCR or debt-to-income ratio. The other elements include:
- Capital: Simply put, capital often refers to a down payment, or the amount of money a borrower can put toward the loan. A borrower is less likely to walk away from a loan the greater the down payment.
- Conditions: Conditions have traditionally represented the terms of the loan – including principal balance, payment terms, and interest rate.
- Collateral: Collateral essentially acts as “back up” assurance if the borrower defaults, allowing the lender to recoup potential losses.
- Character: Character can be difficult to quantify – especially in booming economic times. Often, banks and credit unions rely on FICO credit scores to assess a borrower’s character.
Today, two other “C” essentials should be considered when assessing credit risk: cash position and coronavirus.
“In 2021, when you’re looking at a customer or a member applying for a loan, the question you need to ask yourself is, ‘How has the pandemic impact or changed the income or cash flow generated by this borrower,” Newberry said.
Has the borrower’s industry been significantly impacted, such as a bar or restaurant operating at limited capacity? The pandemic has not only affected the debt side of the balance sheet, but also borrowers’ cash position. Has the borrower been impacted by stimulus payments or Paycheck Protection Program (PPP) loans? What will happen if the borrower doesn’t receive additional payments? While the five Cs will always be critical to assessing credit risk, credit analysts should highly consider the two additional Cs, “Coronavirus” and “Cash Position,” in this current environment.
Recommending decisions
Writing credit memos
Credit memos can be one of the most difficult aspects of credit analysis for financial institutions to wrap their arms around, yet they are one of the most important documents in the life of a loan. The loan committee will use credit memos to decide whether or not it will approve the loan, and the lender will want to show a complete picture of the borrower in the interest of the financial institution’s risk management. Credit memos should be consistently applied, although different templates can be used for industry vertical, loan amount, review type (i.e., new, renewal), and loan type. While the institution may use different templates, each should have many of the same elements to ensure consistency and for board members to quickly look for key items to make a quick decision. To provide enough information for the loan committee members to make a decision without overwhelming them with details, Newberry recommends the following best practices:
- Limit the credit memo to two pages or less
- Include customer overview and final loan recommendation
- Summarize risk score, terms, pricing, and any covenants
- Highlight key financials and ratios
- Include a quick industry overview
- Identify any exceptions to loan policy
- Provide additional supporting information
- Global cash flows (if customer own multiple companies)
- Guarantor analysis
- Collateral analysis
- Additional customer products and account information
- Customer’s business plan
While the templates and information may differ, loan committee members should know exactly where to find the information they’re looking for. Newberry encourages credit analysts to stick to their templates and use standard memos whenever possible. Similar to the risk scoring model, Newberry strongly advocates for recommendations within the credit memo to be made through an objective analysis.
The current economic environment creates new challenges for credit analysts, but it also creates new opportunities to refine and change how financial institutions assess credit risk. Each institution has its own appetite for risk, and its ability to analyze, grade, and determine risk should be tailored to fit the bank or credit union.
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