When I was working for a bank in Washington DC, I had co-workers come to me and ask where they could go to get business lending training. They also wanted to know how I learned to analyze business loans. You would think those would be easy questions to answer, but unfortunately, they are convoluted.
Where I received my training was mostly on the job. I did attend some classes with the FDIC, but those were restricted primarily to regulators. My co-workers complained that on-the-job experience wasn’t a luxury they had, and that they needed some sort of outside training. Since the classes I took were off-limits to the general public, where could they go?
There are some classes out there, but they are few and far between. And, the classes tend to take the “kitchen sink” approach; that is, they throw everything at you, including the kitchen sink, and do not leave you with much context to sort out how to apply the methods they teach. The reality is, most people learn from seasoned coworkers or in larger institutions that have specialized departments. If your institution has access to neither, you are in a tough spot.
I think the lack of access to training on business loan principles is a problem for all financial institutions. When the staff at an institution does not have adequate training, but engage in business lending, two outcomes usually result. Lenders usually extend credit on the basis of having collateral or the basis of having good character. Could either of these situations result in adverse problems?
Collateral-dependent loans, or collateral lending, are the idea that so long as collateral is present, then risk is seriously mitigated. This approach is problematic, because liquidating collateral should only be a means of last resort. There will be no emphasis placed on understanding cash flow, the primary source of repayment, and an institution will find it is expensive and burdensome to liquidate collateral. Furthermore, these types of lending decisions may overly rely upon what an appraiser’s opined value is, which can often differ drastically from the actual value the institution will receive from a sale. In short, collateral lending seriously underestimates the risk and costs of the transaction.
Character loans also lead to faulty judgments. In these decisions, the borrower is trusted that he will repay whatever he asks for, and would only ask for credit if he was sure he was able to repay. Thus, the lender does not put much analysis into repayment, given the customer will understand the repayment better than the lender. There often appears to be the belief that a customer better understands what he is capable of than the lender.
While the lender may not know the borrower’s business as well as the borrower, it behooves the lender to verify that the borrower’s cash flow can repay the debt. Often, borrowers need assistance in getting the correct credit facility, and borrowers may be lack an understanding cash flow and credit which has led to the customer requesting a new business loan. Character lending may appear to be helping someone out, but it could be a short term fix and could ultimately cause the borrower more harm in the future with bigger losses.
Most institutions understand the dangers of character lending and collateral lending, and know it is no substitute for sound credit principles. We recognize that access to training for these sound credit principles is a problem, and we are taking steps to mitigate this. In the near future, we hope to further our mission as a business lending CUSO by providing our area CUs with credit classes, and ones that will be well-reasoned without using the kitchen sink approach.