Commercial risk rating: Case study

Banks and credit unions are in the business of measuring and managing credit risk. At a recent Sageworks event, we discussed a specific case study regarding components of risk rating for a particular business loan to see how the institutions in the audience would have handled a particular scenario.

Situation: Steve’s Soups, a local catering company, has a 7-year loan with the institution, now in its 4th year. To date the business has been growing revenues at a somewhat steady but conservative rate. The borrower has also made payments on time and is currently a Risk Rating 3 – Average/Modest Risk, mostly because of the company’s current financial statement condition and capital.

Update: Through local networking, the institution learns that Steve’s Soups lost its primary client – a local nursing home – that had been responsible for 30% of Steve’s Soup revenue.

Does the institution need to re-risk rate the loan now, or should it wait until cash flow depletes to the point that timely payments cannot be made?

Working through this case study, the experienced bankers at the Sageworks event had a mix of responses that factored into these recommendations.

Recommendations:
1. Place the borrower on the Watch List. This may be one of several Risk Ratings, depending on the matrix the institution uses. With this new information, the borrower should be reassigned to ensure it receives appropriate attention.

2. Conduct a borrower interview. The institution may have happened upon this information on its own, but it merits on onsite visit, with at least 2 goals:

• What led to the lost customer? This may be a difficult question, but the underlying concern is whether Steve’s Soups has a bigger problem that may continue to cause lost clients – perhaps a new competitive threat entered the market, they changed their product line, etc. Each of these factors could play into the business’s future capacity to service debt.

• Is there a plan to make up for that lost revenue? Maybe Steve’s Soups has an additional client waiting in the wings, or the firm has plans to open up a restaurant to replace the catering revenue. Whatever the plan, it’s appropriate to ask for updated business projections showing expected revenues and margins.

3. Review the loan terms. Policy and procedures at the institution should dictate how often Steve’s Soups should provide updated financial information. However, it’s worth reviewing the terms of this specific loan to ensure document requests are made at a frequent enough interval and that the right information is being requested so the loan officer can make an informed decision.

During the case study discussion, the bankers also raised some good points of clarification for risk rating best practices:

• Attention paid to this loan should be commensurate to the size of the credit. If the loan is a larger exposure, reactions to this information may be even more proactive.

• The risk rating may not need to change significantly if the business has little other debt. If DSCR is still high, the risk to the institution may not be as problematic.

For more information on how to monitor credit quality, download this whitepaper: Risk Rating: The common language of credit.