Commercial Credit Analysis 101: Back to Basics

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 essential 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.

Understanding Credit Risk

All 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.

Essentially, we’re going to take folks’ money and we’re going to either buy investments or lend it out to other members through loans, and we’re hoping that those folks we lend it to pay us back so that when the depositor wants to withdraw their funds, it’s there for them.

Credit analysts want to ensure their credit union is making safe loans. To do so, credit analysts use loan classification and credit grading systems to effectively assign credit risk to a loan. Loan grading should include the following three attributes:

1. It should promptly identify loans with potential credit weakness.

2. 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.

3. 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. The difference between the two comes down to timing of when the analysis occurs. The term underwriting is typically used if the loan has not been issued yet. As a credit analyst, you can still add covenants and adjust terms and pricing to account for the risk that exists. Loan grading, on the other hand, is completed after the loan is already on your balance sheet. Credit analysts can still use the same risk scoring matrix or model to assign risk but have limited options to mitigate credit risk.

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. One-third of credit analysis professionals (34%) responding to a recent poll by Abrigo said that qualitative factors make up at least 50% of their scorecards. Meanwhile, one out of five respondents said their scorecards were almost entirely made up of quantitative factors.

As for the loan grading scale itself, consider how wide and many points to include in the scale. Too few and the credit analysts will likely understate risky loans; too many and you will start getting diminishing returns. I frequently recommend a numeric eight- to nine-point scale, which gives analysts enough dispersion of the loan portfolio. The loan grading scale should look like a bell curve when each loan in the portfolio is mapped out, with most loans falling in buckets three and four.

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, I find that 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 critical of the five Cs. To understand cash flow, most credit unions will use a DSCR or debt-to-income (DTI) ratio to assess the member’s ability to pay back the loan. 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, credit unions rely on FICO credit scores to assess a borrower’s character.

Today, two new “Cs” should be considered when assessing credit risk: Cash position and coronavirus.

In 2021, when you’re looking at a member applying for a loan, the question you should be asking yourself is, how has the pandemic impacted or changed the income or cash flow generated by this borrower? Has the member’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 members’ cash position. Has the borrower been impacted by stimulus payments or Paycheck Protection Program (PPP) loans? What will happen if the member 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.

Writing Credit Memos

Credit memos can be one of the most difficult aspects for credit analysis of credit unions 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 credit union’s risk management. Credit memos should be consistently applied, although different templates can be used for industry verticals, loan amount, review type (i.e., new, renewal) and loan type. While the credit union 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, consider the following best practices:

• Include an executive summary in the credit memo (limit this to two pages or less);
• Include member 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; and
• Provide additional supporting information: Global cash flows (if the member owns multiple companies), guarantor analysis, collateral analysis, additional member products and account information and/or the member’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. Credit analysts should stick to their templates and use standard memos whenever possible. Like the risk scoring model, recommendations within the credit memo should 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 credit unions assess credit risk. Each credit union has its own appetite for risk, and its ability to analyze, grade and determine risk should be tailored to fit the credit union.

Rob Newberry is a Senior Advisor for the Austin, Texas-based Abrigo Advisory Services.