Guest Opinion: Before you call banks stingy, learn the five C’s

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It might seem that banks have purposefully set out to make life difficult for would-be borrowers by refusing loans.

I can’t comment on each bank across the nation and its appetite for loans, but I can say that most banks in the Richmond area have money available to lend and are anxious to talk to qualified prospective customers. Show me a seasoned company with consistent, profitable results looking to borrow, and I’ll show you at least three local banks fighting over the deal. But the companies that could get approved for a new lending request are not seeking new credit. Many of the companies that are seeking new lending requests need a loan, either to get them out of a pressured relationship at another bank, cover recent operating losses, or provide interest carry for a losing proposition, none of which are attractive to most banks.

The other thing people forget: Banks need to make loans. Loan production is the lifeblood of banking. Commercial loans have an average life of between three and five years.  Simply through their natural life cycle, loans are constantly paying off. If new loans are not booked to replace the loans that are paying off, then a bank’s interest income will quickly drop, causing an instant ill effect on its net income.

That said, any business in search of a loan needs to think like a banker for a moment in order to strengthen their case. Ask any good loan officer how they underwrites a loan request, and you are likely to learn about the five C’s of lending: capacity, capital, collateral, credit and character.  These are generally accepted as the best way to ascertain a borrower’s credit-worthiness.

A potential borrower’s capacity is a gauge of his qualification to receive the loan that has been requested. The lender will set out to determine whether the borrower is pursuing a plan within his talents and means. A borrower’s experience in the market, track record in business and education might all be considered. Never laid a brick?  Then you’re probably not a good candidate for financing to start a masonry company.

Capital is traditionally defined as the percentage of the total cost of the project that is to be contributed by the borrower.  A bank will always require that the borrower also have capital at stake. Often referred to as having some “skin in the game,” capital helps to ensure that the borrower is fully committed to the deal, and it also serves to reduce the bank’s exposure to loss.

Collateral serves to demonstrate the borrower’s ability to cover the loan with tangible assets as an alternate source of repayment. All collateral is not created equally, as banks prefer liquid collateral such as certificates of deposit or a stock portfolio over hard-to-value assets such as your time-share in the Poconos or your 1982 Yugo. If pledging illiquid collateral, expect the bank to accept it on a discounted basis.  This will offer the bank a margin to cover the costs involved in converting the asset to cash, should the loan default.

Analyzing the prospective borrower’s credit provides a glimpse of how the business or its owners will pay back the loan. What is the borrower’s personal credit history? Does the business generate enough cash to cover the resulting loan payments?  Is there additional cash on hand to cover any unforeseen cost overruns? How many other loans is the borrower currently paying at other banks? All of these questions need to be answered to determine if the borrower has the necessary credit to get the loan approved.
Finally, the borrower’s character must be assessed. While impossible to accomplish through a mathematical equation, this “C” is every bit as important as the others.

So let us return to the current financial crisis: Bankers are working through these five C’s in their underwriting more than ever.  My guess is that many of the recently denied loan applicants making the headlines fell short in one or more of these areas. Even existing borrowers may find that with the currently depressed and sometimes unknown real estate values, they are struggling with the collateral “C” for the first time in years.

Does this mean that lending has reverted back to the practice of years long past when a bank would loan a customer $1 for every $1 that they could offer as liquid collateral?  Not entirely. Rather than focusing on how to sell a bank on your loan request (“It is going to be the next Google!  There is no way it won’t succeed!”), try to sell the bank on how your request won’t cause it to lose any money. Help the bank to mitigate the risk that it perceives in the deal.

For starters, try walking through the five C’s with your loan officer. If there is one area that is lacking, try to offset the weakness by adjusting another aspect of the request. If the borrower has questionable credit, maybe he could offer additional collateral.  Likewise, if capital is lacking, offer for the bank to hold a lien against an unrelated asset until the project has stabilized. If the bank is nervous about the collateral, the borrower can offer to accommodate a faster amortization period. The faster the loan is paid down, the faster the bank will achieve a comfortable collateral position.  For real estate purchase transactions, ask if the seller will consider holding a note that is subordinate to the bank.

In doing so, you have effectively reduced the bank’s risk at no cost to you.

It is important to remember that within a typical bank deal with 20 percent capital offered by the borrower, the bank is still taking the majority of the risk (80 percent). What’s more, the bank isn’t investing its corporate money into the deal; it is investing its depositor’s money. If the deal goes bad, the bank has everything to lose. If the deal does in fact turn out to be the next Google, the bank doesn’t get to share in the profits – it still only makes its small interest spread.

So the next time you hear about the would-be borrower that was denied a loan to finance the start-up of a new Spatula City location, realize that there is likely more to the story than simply a big, bad bank looking to hoard its cash rather than lend it out.