As we all know, risk is part of our daily life. We all take a risk just by getting into our cars in the morning and driving to work. We know that the odds are in our favor that we will make it to work alright, if we drive responsibly and watch out for other drivers. I started driving when I was 15 years old and have only been in one accident, and it was when someone hit me from behind while I was waiting at a stoplight!
All business we engage in also have risks that must be navigated, and banks and credit unions spend a significant amount of time trying to understand their risk profile. When lending money, the main risk we are concerned with is not getting repaid. How much risk is acceptable? If our odds of getting repaid are 50%, is this a good risk to take? If our odds of getting repaid are 75%, is this a good risk to take?
To answer how much risk is acceptable, we need to understand the ability to absorb our risk of default. What a financial institution falls back on is capital. If a loan goes bad, the institution will have to record the loss as a loss to capital, and it cannot record it as a loss to depositors. When capital runs out, the regulators shut down the institution. So, it is capital that ultimately limits how much loss or risk of loss an institution can take.
Consider that most financial institutions have a capital ratio of around 10% of total assets. That means, even if the odds of getting repaid by loans were 90%, the risk of 10% of loans going bad would deplete the entire capital of the institution! That means an institution has to do better than a 90% chance of getting repaid.
A healthy bank or credit union can grow its capital at a rate of 1% of assets per year. That means, if losses were to be any greater than 1% a year, then an institution is losing capital at a rate faster than it can replenish. That also means a healthy institution could hypothetically see 1% of loans go bad in a year, indicating they must be right 99% of the time!
Of course, institutions would like to grow and need capital to do so. If their capital growth was constantly offset with losses, they wouldn’t grow at all. So realistically, an institution would like to get it right greater than 99% of the time.
This means banks and credit unions rely on loans that have a 99% chance or greater of getting repaid. We refer to these loans as “bankable” assets. When there is sufficient cash flow, collateral, and a high probability of repayment, we say that the loan is a “bankable” asset.
A misunderstanding I often run across is lenders or small business owners see great potential for their business, but they don’t understand why an institution will not readily finance their business. I would agree that a business that has a 90% chance of repayment sounds promising, but unfortunately, it isn’t bankable. That isn’t to say it’s a bad business venture. Many of these businesses are worthy of investment from some other source, but it simply is too risky to be funded by depositor money.
To summarize, the odds of repayment must be exceptionally high for a loan to be considered “bankable.” Even if odds of repayment are high, the loan request may still not be bankable. The loan must demonstrate enough collateral, cash flow, and positive business conditions that it is a 99% or greater chance repayment will occur. This means even a good business isn’t always a bankable business, and sometimes a good business will need to seek a different form of investment other than debt from banks or credit unions.