RETAIL BANKING ACADEMY. Course Code SME Lending RETAIL BANKING II 203. DO NOT COPY. SME Lending

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1 203. SME Lending 50

2 Course Code 203 SME Lending Introduction It is conventional wisdom that small and medium size enterprises (SMEs) contribute substantially to economic growth in most countries in the sense that they are the principal source of employment generation and output growth. For example, Gerrit de Wit and Jan de Kok (2014) * report that small firms in the European Union as a whole contribute on a greater scale towards job creation than larger firms, a finding that is similar for the US (Neumark et al, 2011). An interesting comparison of the role of SMEs in enhancing national economic growth for both developed and developing countries is provided by Pandya (2012). Not surprisingly there is no consistent definition of SMEs across economies and proposed definitions vary country by country. A firm that is defined as small in a developed country may be regarded as large in one that is emerging. For example, in Egypt, an SME is defined as having between five and 50 employees, whereas in the EU an SME is one that has fewer than 250 employees. The Inter-American Development Bank defines an SME as having no more than 100 employees and less than US$3 million in turnover (i.e., revenue) while in the US an SME has less than 500 employees. Finally, as a general guideline, the World Bank defines an SME as having less than 300 employees, US$15 million in total revenue and US$15 million in total assets. So SME lending has a direct effect on national economic growth. But SME lending can be quite risky for banks. The main reason is that there is considerable informational asymmetry faced by banks. This is because SMEs typically have highly opaque financial statements so that banks must rely on soft data to complement their credit evaluation process. Lending to SMEs typically takes the form of overdrafts, business credit cards, short-term secured and unsecured loans and long-term loans (typically secured). The purpose of SME lending includes working capital financing, trade financing, mortgages for commercial and industrial property, investment in plant and equipment and supply chain financing. * Refer to Do small businesses create more jobs? New evidence for Europe, Small Business Economics, Volume 42, Issue 2, pp (February 2014). Refer to Review of Economics and Statistics, 93(1), page Refer to the article presented at the 2012 International Conference on Business and Management 6 7 September 2012, Phuket, Thailand. Soft data is explained in Chapter 1. Retail Banking Academy,

3 The lending process begins with the loan officer submitting a completed loan application to the risk management department of the bank. Risk management experts evaluate the credit risk of the loan applicant typically using a three-stage lending process screening of the prospective borrower followed by the contracting stage, where terms and conditions are set, and finally the monitoring stage, where credit risk migration is tracked and analysed. We adopt the traditional 5Cs model of commercial lending in our consideration of the three-stage lending process. The remainder of this module is organised as follows: Chapter 1 considers the first stage of the lending to SMEs process: screening. The 5Cs model is the basis for the screening of prospective borrowers. These factors are character, capacity, collateral, capital and conditions. While all five factors are important in establishing the creditworthiness of prospective borrowers, the process defined by the 5Cs model is commonly called collateral-based lending so as to emphasise the collateral requirements imposed by the bank. We also consider the credit risk evaluation procedure for unsecured loans in Chapter 2, where this type of lending is called information-based lending. The bank-customer relationship is examined and the high credit risk associated with new SME borrowers that have been in business less than three years is analysed. If the screening stage results in a decision to proceed with the loan application, then terms and conditions are set (contracting) and the monitoring of credit risk follows. Chapter 2 also deals with these two latter stages and provides a full explanation of the role of the price and non-price terms and conditions. Included are details of how the loan rate is calculated and an extended discussion of the role of funds transfer pricing (FTP) that is presented in Module 206. Chapter 3 deals with the calculation of the expected credit loss that incorporates the realistic assumption that probability of default (PD) and loss given default (LGD) are correlated. This is an input into a model of concentration risk. The potential for the bank s loan portfolio to exhibit concentration risk can be one of the deciding factors in the risk manager s decision to lend to an SME. Accordingly, banks place limits on loan concentration. 52

4 Chapter 1: The Lending Process The Screening Stage It is widely accepted by both academics and practitioners that lenders to SMEs are at a disadvantage when it comes to obtaining valid and reliable information on prospective customers. The list of potential problems includes opaque and unaudited financial statements, encumbered collateral that may also be non-marketable and high debt-to-equity ratios. These are so-called hard data problems. There are also soft data issues that relate to the integrity of the owner(s). While hard data gives the lender a financial picture of the applicant s ability to repay a loan, soft data provides a more subjective indication to the loan officer of the prospective borrower s willingness to make repayments in full and on time. Petersen (2004) * presents a comparison of hard with soft data. He states that hard information is almost always recorded as numbers. Thus in finance we think of financial statements, the history of which payments were made on time, stock returns, and quantity output numbers as being hard information. Soft information is often communicated in text. It includes opinions, ideas, rumours, economic projections, statement of management s future plans, and market commentary. The fact that hard information is quantitative means that it can easily be collected, stored, and transmitted electronically. In short, hard data are quantifiable while soft data are more subjective. Soft data may take on added importance in the lending process when hard data are not complete or reliable. Indeed, to overcome the problems of opaque financial statements, banks can acquire soft data by sending a loan officer to visit the prospective borrowing firm and speak with key personnel to get an evaluation of the firm s creditworthiness. The value of soft data in SME lending is highlighted by numerous researchers in the financial services industry. For example, Chen et al (2013) show that the use of soft information significantly improves the power of default prediction models and hence improves the estimation of expected loan loss. * Mitchell A. Petersen, Information: Hard and Soft, Kellogg School of Management, Northwestern University and NBER. Yehning Chen et al, Soft data and small business lending, Journal of Financial Services Research (November 2013). Retail Banking Academy,

5 The Three-stage Lending Process Lending to SMEs may be characterised by a three-stage process: screening, contracting and monitoring. The screening phase is the start of the lending process, where the lender evaluates the financial health of the business in terms of the firm s ability to repay the loan obligation. It is a data collection stage and a preliminary evaluation of key issues. Typically the last three years financial statements (including a cash flow statement) are reviewed. In addition, a three-year projection is requested for review of business development and ability to pay. Importantly, because of the possible lack of reliable hard data, there is a risk of adverse selection. Indeed, the academic and professional literature has provided evidence that banks face a higher level of adverse selection risk for SMEs compared to larger corporate firms. This is largely due to information risk arising from opaque financial statements. Contracting is the second stage of the lending decision process, where the terms and conditions are set by the lender. These terms and conditions include: the cost of the loan to the customer; the loan amount; the term of the loan; and the requirements for collateral. This stage is considered only if the decision is made to proceed beyond the screening stage. The last stage is the monitoring of the customer s financial condition and risk-taking activities so as to assess credit risk migration over time. It is also an opportunity for the bank to identify potential sources of moral hazard risk. This risk occurs when the customer invests in projects that are riskier than the lender expected, leading to unexpectedly higher credit risk that was not adequately priced at the contracting stage. The three stages of the lending process are facilitated by the 5Cs of commercial lending. We complete an analysis of the screening stage with a discussion of the purpose of the loan, a practical SME lending scorecard based on the 5Cs with indicative scores and practical advice for the loan officer to achieve an effective screening process. The 5Cs of Commercial Lending a Consideration of Collateral-Based Lending The 5Cs of credit paradigm * represents a long-established practice utilised by lenders to screen prospective customers so as to establish their creditworthiness. This paradigm comprises the categories of character, capacity, collateral, capital and conditions. Character is identified with integrity, which shows the borrower s willingness to repay the loan obligation over the term of the loan. Capacity, capital and collateral together form the basis for a quantitative financial analysis. Capacity is a measure of the borrower s ability to repay the loan while capital or equity represents the company s stake. This is a commitment of the owner as pre-emption of moral hazard risk for the lender. Collateral is security against the likelihood of the borrower defaulting and reduces the losses due to default. Conditions refer to external variables such as macroeconomic variables national as well as sector-specific that are likely to impact the future profitability of the firm and thereby influence the migration of credit risk over time. In the rest of this chapter, we examine each of the 5Cs in relation to their respective effects on the creditworthiness of the potential borrower the screening stage. Character Character refers to the integrity of the small business owner(s). Integrity means honouring one s word. Indeed, as asserted by Erhard, Jensen and Zaffron (2013), in summary, we show that defining integrity as honouring one s word and empowers the three virtue phenomena of morality, ethics and legality. * George E. Ruth, Commercial Lending, 5th Edition. See: Werner Erhard, Michael C. Jensen and Steve Zaffron, Integrity: A positive model that incorporates the normal phenomena of morality, ethics and legality, Harvard Business School NOM Working Paper No (SSRN id: ) 54

6 In relation to lending, character has an ethical connotation: a willingness to repay the loan obligation. This is the link to the idea of keeping one s word. How can a bank evaluate a potential borrower s integrity? It is suggested that one way to evaluate integrity is to consider the potential borrower s history of repayment of previous obligations as well as the length of the credit history. In short, integrity must be validated over a minimum period of time. Indeed, as asserted by Ruth (2004, See footnote on previous page), persons lacking character assign a low priority to repaying debts and are quick to default on any loan commitment at the first sign of financial trouble. It is interesting that the FICO credit score (owned by the Fair Isaac Corporation in the United States), which is used to evaluate the creditworthiness of potential borrowers, comprises five factors: payment history; amount owed; length of credit history; credit mix; and new credit. The highest weight of 35 percent is applied to payment history, followed by 30 percent for length of credit history. While many economies (especially, but not only emerging ones) do not have access to a credit score for SMEs, it is recommended that internal credit models should give added significance to these two factors of the FICO score. The value of the customer s integrity is seen to be very important in the practice of SME lending. For example, Amrei Botha, head of SME banking at Standard Bank Africa, stated in an interview (see below) that, in establishing the creditworthiness of loan applicants, added emphasis is placed on the customer s willingness to repay his/her obligations. Prospective clients are asked to fill in a business questionnaire, which gives us an indication of their willingness to repay debt. We also assess their ability to repay by evaluating sales turnover, gleaned from banking records. Unbanked entrepreneurs are asked to transact with us for a month, to make this information available. So essentially what we are trying to assess where an informal business applies for a loan is first of all whether they have the willingness to repay the loan, then second of all, whether they have got the ability to repay the loan, said Botha. Source: The Africa Report, 2 October 2012 In summary, it is recommended that two indicators of character should be applied in the screening stage of the lending process. These are: number of missed payments on all loan obligations; length of repayment history, with a minimum of three years. These indicators give a degree of measurability to character which is normally an example of soft data. While character is a key component of the 5Cs paradigm, it is not sufficient to grant a loan. The following lesson is always important to heed: While good character is not sufficient to grant a loan, bad character (lack of integrity) is sufficient to deny a loan. Good character can be tested by negative economic conditions. This is when individuals of integrity seek to restructure their loan obligations rather than quickly seek to default. The second component of the 5Cs paradigm is Capacity, which measures the customer s ability to prepay the loan obligation. Retail Banking Academy,

7 Capacity * It is understood that net profits do not repay a loan. This section will present a rationale for this statement and recommend that lenders switch from the analysis of SME profitability to producing cash flow projections. The ability of a loan applicant to repay a loan is based on cash flow and not just profitability. Indeed, in the Financial Handbook for SMEs it is noted that most SMEs keep track of their revenue and profits by looking at their profit and loss statement. As long as it shows a profit, entrepreneurs usually assume that profit is the same as cash, but that may not be true. An article in the Daily Telegraph (9 December 2013) makes a key point in relation to the importance of cash flow. There, it was reported that more than 50 percent of SMEs polled in the UK admitted having cash flow concerns. The report implied that this may be the reason why recent funding and lending figures show that access to credit for SMEs remains subdued. Of the one in five small businesses that applied for a loan in the past two years, more than half had their application rejected or are still waiting for feedback. We now examine some cash flow ratios that are typically used by lenders to assess the borrower s ability to repay its loan obligations. Firstly, we consider a measure of cash flow earnings before interest, taxes, depreciation and amortisation (EBITDA). EBITDA is defined simply as total revenues less operating expenses excluding depreciation and amortisation and before interest and tax payments. Hence, it is a measure of operating cash flow. Here is a simple income statement of an SME that illustrates the calculation of EBITDA. Income Statement for the year ending 31 December 2013 (All monetary values are stated in thousands of dollars) Revenues 5,060 Total Operating Expenses (OPEX) 3,130 Interest Expense 250 Depreciation & Amortisation 370 Taxes (20 %) 336 Net Earnings 1,344 In this case, EBITDA = (5,060 3,130) = 2,300. Note that OPEX includes depreciation and amortisation which is added back to obtain a value for EBITDA. A common ratio that measures an SME s operating cash flow relative to the interest it pays on total outstanding debt is Interest Coverage Ratio (ICR). ICR is calculated as follows: ICR = EBITDA Total Interest Payments In our example, ICR = 2,300 / 250 = 9.2. This means that the current level of EBITDA covers 9.2 times the current level of interest payments. While this ratio is relatively simple and easy to calculate, one of its major drawbacks is that an SME s EBITDA is likely to fluctuate much more than its interest payments. Hence, projections of ICR are likely to be unreliable. In addition, * As a first step, the loan officer must ensure that the borrower has legal capacity to act on behalf of the SME. Financial Handbook for SMEs (Action Community for Entrepreneurship, The Association of Banks in Singapore, 2007) 56

8 interest expense may not represent all of the SME s total debt obligations. For example, it does not account for mandatory principal repayments. It should be noted that capacity summarises the SME s ability to repay its loan obligations and hence ratios should be based on cash flows. EBITDA does not include interest, taxes or required asset investments. All of these are real cash expenses and should be considered when evaluating a company s ability to repay its total debt obligations. Accordingly, banks consider total debt service ratio (TDSR) as a relatively more reliable indicator of the SME s ability to repay its total debt obligations. The formula for TDSR is defined as follows: EBITDA Taxes & Investments TDSR = Total Interest & Principal Repayments A value for TDSR that is below 1.2 is viewed as high risk; a value above 1.5 indicates low risk while a value within this range is considered as medium risk. Evaluation of a New Loan Obligation One approach for the evaluation of a new loan obligation is to consider the SME s debt service ratio (DSR), which compares the SME s free cash flow (FCF) with the terms of the new loan obligation. First we present the procedure for the calculation of FCF: FCF = EBITDA Existing (Interest Expense and Mandatory Principal Repayments) Projected tax payments Change in Working Capital Requirements * Required Replacement Investment Expenditure A positive FCF reflects the SME s ability to finance new loans. Simply put, the SME s FCF is what is available to finance new loans. We now present the formula for DSR as: FCF DSR = New( InterestExpense + Mandatory Principal Repayments) This ratio typically ranges between two and four and the choice of a minimum value by the lender depends on several factors including its risk appetite, age of the business, portfolio concentration and sector risk. Although we have presented the procedure to calculate the value of financial ratios for one period, it is important to examine the trend in the values of this ratio over time. For example, a relatively stable and high ratio for DSR that is calculated on a quarterly basis over a three-year period provides a degree of assurance that that trend is likely to continue. One of the principles of commercial lending is commonly described as the Two Ways Out, which means that the borrower must have two distinct and independent ways of repaying the loan. Adequate free cash flow is one of these two ways out. The most common second way is the provision of collateral that may be liquidated to recover the bank s outstanding exposure. We now consider the role of Collateral in the screening of potential SME borrowers. * Note that a negative change will increase free cash flow while a positive change will result in a decrease. To fully understand this point, consider Question 3 of the Multiple Choice Questions at the end of this module. Retail Banking Academy,

9 Collateral Collateral is an asset or set of assets that are pledged by the borrower to secure a loan. These assets typically can include accounts receivable, inventory, equipment and real estate. They constitute a secondary source of loan repayment should the borrower be unable or unwilling to repay the full amount. But non-interest earning assets, in particular, which are pledged as collateral may themselves become impaired and lose value over time. Hence, in converting collateral to cash at the time of default, the lender may find the recovery (market) value to be lower than expected. This is termed a collateral gap when asset values decline in the markets. As reported in the Wall Street Journal (22 July 2010), many small businesses, thwarted in efforts to get loans, are saying it takes money to get money. That s because property and equipment assets have fallen in value, so businesses seeking loans are being asked for alternative collateral, often in the form of cash so that the loan is backed in case the borrower defaults. According to Kathie Sowa, a commercial banking executive at Bank of America Corp., one of the nation s largest small-business lenders, basic underwriting standards haven t changed: Cash flow must be sufficient to support the loan, and there must be a secondary source of repayment. Collateral was typically a combination of accounts receivables, inventory, real estate, equipment, and other business or personal assets. But since real-estate and equipment values have plummeted, she says, business owners who may have landed loans in the past are now falling short of having sufficient assets. We now ask the key question why do banks (sometimes) require collateral? As already stated above, one can reason that collateral provides a reduction in the risk of a loss to the bank should the borrower default. It is a second source of repayment. Loss given default (LGD) is reduced and hence the recovery rate is increased. But there are other reasons why a bank might require collateral from an SME. Three such reasons are proposed in the professional literature. We consider each in turn. a) It is well-accepted that banks as lenders have an informational disadvantage compared to the borrower, who typically has quite opaque financial statements. One implication is that borrowers, after the loan is granted, may take on projects with risk levels that are higher than the bank expected. This can put the bank s loan repayment in jeopardy should such a project fail. This is the classic moral hazard problem. By being required to provide collateral, the borrower has an interest in curtailing high-risk activities. This occurs at the monitoring stage of the lending process and is fully discussed in Chapter 2. b) The informational disadvantage referred to in a) above also creates a problem for the bank at the screening stage of the lending process before the loan is granted. This is the classic adverse selection problem in lending where some information is hidden from the bank. As stated by Bester (1985) *, if the bank cannot discern borrowers riskiness because of hidden information, then collateral may serve as a screening device to distinguish between borrowers and to mitigate the adverse selection problem. Specifically, this literature states that lower-risk customers are likely to willingly provide collateral while high-risk customers are less likely to respond positively to the bank s request for collateral. This follows from the observation that a lower-risk borrower has a greater incentive to pledge collateral than a risky borrower, because of his lower probability of failure and loss of collateral. The bank then lowers its risk of adverse selection. This is called the adverse-selection hypothesis, and it occurs at the screening stage of the lending process. c) The last rationale for the bank requiring collateral is based on what is commonly called the observed-risk hypothesis. This states that banks charge riskier borrowers higher loan rates and require higher collateral from these borrowers. Hence, there is a positive relationship between risky customers and the requirement for collateral. This also occurs at the screening stage of the lending process. * H. Bester, Screening vs. Rationing in Credit Markets with Imperfect Information, The American Economic Review 75(4), (1985). 58

10 So, we see that there are three reasons why a bank requires collateral reduction of loan loss in the event of default, mitigating the risk of adverse selection and moral hazard. In a study of 5, 843 loans made to borrowers located in 43 countries, Laurent Weill and Christophe Godlewski * provided evidence showing support for the adverse selection and observed-risk hypotheses, as both hypotheses may be empirically validated depending on the degree of information asymmetries in the country. What is the lesson from this study? When there is a high level of information asymmetry, as may be the case in emerging economies (so that the bank has a significant information disadvantage), banks require more collateral as part of their screening process in an effort to compensate for hidden information that could lead the bank to make adverse selection (i.e., wrong choice of a borrower). We now consider another factor in the 5Cs paradigm Capital. Capital Capital, also known as shareholder equity, is the difference between the accounting value of assets and liabilities and represents the owner s equity stake in the company. It represents the owners stake and lenders look to a high value of shareholder equity relative to the amount of long-term debt as an indication of the total risk of the company. An important accounting ratio in this regard is the debt-to-equity ratio which is a measure of the long-term solvency of the company. It is defined as the accounting value of long-term debt divided by owners equity. There are some important considerations of this key ratio. a) A high value of debt-to-equity implies that the company already has a high level of debt relative to the owners stake. This could mean that total current interest expense is quite high, which may negatively affect the free cash flow of the company. The company s ability to repay additional loan obligations may be negatively affected i.e., capacity suffers. b) While we asserted above that net profits do not repay loans but cash flow does, there is an important implication when a company is unable to create positive profits over time. This arises from the fact that net profits (positive or negative) become retained earnings (after possible dividend payments) in the next accounting period. A loss would mean negative retained earnings and hence, all else being equal, a reduction in owners equity leading to a higher debt-to-equity ratio. It can also lead to moral hazard problems for the bank if the owners equity is reduced sufficiently and owners seek high-risk investments to earn a higher level of profits. c) An erosion of accounting value of the company s assets due to, for example, increased depreciation and amortisation or impairments will reduce asset values and lower owners equity. Since there is no change in the amount of long-term debt, the debt-to-equity ratio will increase and the company s risk of insolvency will increase. Accordingly, a thorough analysis of the company s business plan, balance sheet, profit and loss statement and cash flow statement is required to obtain a full and transparent picture of the company s long-term viability. This is evidenced in part by the debt-to-equity ratio. While there is no hard and fast rule, a common level for the maximum value of the debt-to-equity ratio is two to one. This means that a bank may not lend to a company where the debt-to-equity ratio is already at two to one. But lending practices vary in different market conditions and depend on the borrower s Capacity (ability to repay) as well as Character (willingness to repay). * University of Strasbourg (November 2006). There are several variants of the debt-to-equity ratio. One version considers total debt to equity where total debt is the sum of short-term and long-term debt. Retail Banking Academy,

11 Similar to the recommendation made for the ICR and TDSR, the bank requires three-year projections of the debt-to-equity ratio on an annual basis. The final component is Conditions, which refers to current and anticipated economic and market conditions facing the prospective borrower. Conditions In screening prospective borrowers, the bank must assess the probability of default over the proposed term of the loan. Clearly, credit risk varies over time and hence it is important to assess future macroeconomic conditions international, national and local in order to assess potential sources of future credit risk. For example, a forecast of a downturn in the national economy might increase unemployment, which could adversely affect the business of the prospective borrower. This would reduce the borrower s ability to repay the loan obligations (i.e., Capacity) and may lead to a higher probability of default (PD). Further, asset values may decline in capital markets so that collateral values may be reduced, leading to a higher loss given default (LGD). We see that market conditions can have a dual impact on PD as well as on LGD. Negative economic events can increase both PD and LGD leading to higher credit risk than existed at the beginning of the screening process. Hence, the loan officer must seek the expertise of the bank s economists in order to assess the prospective borrower s vulnerability to the forecasted economic conditions. The increased risk may lead to a denial of the loan or the requirement for a higher level of good quality collateral. The above analysis of the 5Cs of lending to SMEs shows that the five factors are inter-related and hence should not be considered in the screening as if they are independent. Here are some interrelationships that are noteworthy: Capital a high debt-to-equity ratio can lead to higher principal repayments and interest expense and a lower free cash flow leading to lower ability to repay loan obligations (Capacity); Conditions forecasts of an economic downturn may increase credit risk over time leading to a denial of the loan request or a requirement for a higher level of good quality collateral. We now consider another key factor that a bank typically considers in its screening process the purpose of the loan. Generally, SMEs seek bank loan financing for three main reasons: a) Improve short-term liquidity by seeking working capital loans or an increase in the limits of lines of credit; b) Replace inefficient or depreciated assets such as equipment and, c) Invest in projects for higher profitability, market share or increased net cash flow. Banks typically prefer to invest in option c) since these projects are expected to generate cash flows to finance the new loan. Banks do not typically look favourably at working capital loans intended to enhance short-term liquidity since there may be operational issues in the SME that should first be addressed before seeking a loan. For example, there may be problems with collecting receivables, unduly high inventory levels and low cash and cash equivalents. As a general rule, a positive value of TDSR implies that the SME has a positive level of free cash flow implying that a) and b) are covered. This leaves c) as a bank s preferred reason to lend to an SME. Finally, in this section, we provide a summary of practical advice for loan officers in their screening process. 60

12 Advice for Loan Officers Screening Stage 1. Have a second source of repayment e.g. collateral or personal guarantees for family-owned businesses. 2. Know the principals of the SME as well as the type of business the SME is in. 3. Seek the advice of senior business and risk managers when you are dealing with a new loan applicant or an SME that is new in business. 4. Have effective documentation to support the screening stage. 5. Place a higher weighting on cash flow than on profitably. 6. Be aware of the value of soft data. We close this chapter with a recommended SME Lending Scorecard that is based on the 5Cs paradigm. We propose an indicator attribute for each of the 5Cs with a suggested scoring scheme. * 5Cs LOW-RISK MEDIUM-RISK HIGH-RISK CHARACTER Number of Missed Payments (Payment History 3 years) CAPACITY 0 1 > 1 Total Debt Service Ratio (TDSR) > 1.5 Between 1.2 and 1.5 inclusive Debt Service Ratio (DSR) > 4 Between 2 and 4 inclusive < 2 COLLATERAL ASSET < 1.2 Class of Committed Asset * Level 1 Level 2 Level 3 CAPITAL Debt-Equity Ratio (D/E) < 1 Between 1 and 2 inclusive CONDITIONS Forecasted Business Cycle Upturn Stable Downturn An overall scoring scheme is proposed as follows: > 2 An SME loan applicant is scored as LOW-RISK if all indicator attributes are scored as low risk; An SME loan applicant is scored as HIGH-RISK if at least one indicator attribute is scored as high risk; If the SME loan applicant is scored as neither low-risk nor high-risk then the defaulting score is MEDIUM-RISK. Comment If the loan officer cannot take mitigating actions (e.g. seek better quality collateral or personal guarantees), then SME loan applicants that are scored as high-risk are to be eliminated from further consideration. Medium-risk loans may only be considered if sufficient mitigating * These levels refer to IFRS classifications of availability of market prices to value assets. Retail Banking Academy,

13 measures can be taken. If the decision is to proceed, then the contracting and monitoring stages follow. Chapter 2 deals with these two remaining stages of the lending process for both collateral-based and information-based lending. 62

14 Chapter 2: The Lending Process Contracting and Monitoring Contracting comes into effect after the risk manager has decided that screening of the creditworthiness of the prospective borrower has revealed positive results. This stage specifies a set of terms and conditions that are intended to: mitigate the borrower s credit risk for the bank and, increase the bank s ability to monitor credit risk migration over the term of the loan. It is important that the terms and conditions set by the loan officer must also facilitate effective monitoring after the loan is granted. Terms and conditions fall into two main categories: a) price of the loan and, b) non-price aspects that can include collateral requirement, loan size, loan maturity and loan covenants. There are generally two approaches utilised by a bank to set the price of a loan. Firstly, the price is based on the combination of the bank s cost of funding through a fund transfer pricing procedure and a target profit margin where the latter reflects competitive pressures. This is sometimes called uniform pricing. But uniform pricing does not consider sources of risk that are specific to the loan applicant. To deal with these additional sources of risk, the loan officer will make adjustments to non-price terms and conditions such as loan size, loan maturity, loan covenants and collateral requirement. The second approach to pricing of loans to SMEs is based on the level of credit risk incurred by the bank by lending to the particular SME. This procedure is called risk-based pricing *. This methodology results in differential loan prices according to the riskiness of the prospective borrowers. An added benefit of this approach is that it is possible to link the price of the loan to a Risk Adjusted Return on Capital (RAROC) benchmark set by the bank. However, there is evidence that banks more often adopt the uniform pricing method to set SME loan interest rates. Since risk-based pricing is fully explained in Module 209 and is not commonly used by banks to obtain * Details of risk-based pricing are presented in module 209, which deals with risk management. Retail Banking Academy,

15 customer loan prices, we only consider the details of the uniform pricing approach in this chapter. The remainder of this chapter deals with price and non-price terms and conditions that are applied to the contracting and monitoring stages of the lending process to SMEs. Pricing of Loans to SMEs We now deal with the details of uniform pricing, where all SMEs are charged the same price for a same loan duration, although small variations are possible, if, for example, collateral commitments comprise mostly liquid assets. As an illustration, ICBC (Asia) currently offers the prime rate plus one percent to all SME customers for unsecured loans over a three-year term. All qualified customers will receive this price, although small discounts resulting in a price such as prime rate + 50 basis points may be offered to some SMEs which have a long-term relationship with the bank or which have additional business with the bank. But the key guideline remains: Terms and Conditions for a Loan to a Particular SME = Identical Loan Rate for Borrowers + Non-Price Terms and Conditions that Incorporate the SPECIFIC risks of the SME Uniform Loan Pricing Model There are different approaches to obtaining loan prices. We provide a review of a popular model that is supported by the Global Association of Risk Professionals (GARP) in its professional examination for Financial Risk Managers (FRM) and then consider our preferred approach that is based on funds transfer pricing (FTP), a procedure that is fully explained in Module 207. The description of the FTP is enhanced by a consideration of the markup for credit risk, liquidity risk and optionality risk. Saunders * presents a formula which may be stated, using the symbols in Module 207, as follows: L = f + m + FTP where: L = customer loan rate; f = average acquisition and servicing costs over the duration of the loan; m = target profit that includes expected loss on the loan; FTP = reference (interbank) swap rate + markup for liquidity risk + markup for optionality risk We rewrite the loan pricing model as follows: Since FTP = reference (interbank) swap rate + liquidity markup + optionality markup, we have: L= f+m+ interbank swap rate + liquidity markup +optionality markup We now consider non-price terms and condition of a commercial loan to prospective SME borrowers and show how the markups on credit risk, liquidity risk and optionality are managed by risk managers. * See: Anthony Saunders, Credit Risk Measurement, (New York: John Wiley & Sons, 1999). 64

16 Non-price Terms and Conditions We stated in Chapter 1 that collateral is traditionally viewed as a risk-reducing contractual feature; it serves to compensate moral hazard risk for the bank and is potentially an effective screening device for prospective borrowers with hidden information and thereby reduces adverse selection risk for the lender. Banks are at an informational disadvantage when dealing with SMEs, which typically have unaudited and highly opaque financial statements and are not normally evaluated by ratings agencies nor followed by the financial press. In this section we: consider some practical issues such as guidelines for setting the amount and type of collateral; advise caution to loan officers who may inadvertently succumb to the so-called lazy bank hypothesis and finally; consider the role of the duration of the bank-customer relationship in determining collateral requirements by the bank. Collateral, Haircut and Maximum Loan Amount The (monetary) amount of collateral required for a loan is impacted by a haircut applied by the bank to the stated collateral value. Specifically, an estimate of the market value of the collateral is determined by the bank s specialists and then a haircut (i.e., a discount percentage factor) is applied to determine the maximum loan amount. For example, if the market value of the asset that will serve to secure the loan is $1 million, and the bank applies a 30 percent haircut, then the maximum loan amount is 70 percent of the value of the collateral or $700,000. Formally, Maximum Loan Amount = Collateral Value x (100% - Haircut (%)) This formula is related to the traditional loan-to-value (LTV) ratio which measures loan value to market value. In the example above, the max LTV is equal to 70 percent since the haircut is 30 percent. Two issues are immediately evident. These are: a) How to estimate the market value of the collateral asset? b) What is the appropriate haircut percentage? We consider each of these questions in turn. The accounting profession * has classified assets into three categories the so-called three-level hierarchy. The first is Level 1 where these assets are traded on an active and liquid market and market quotes are readily available. This is sometimes called mark-to-market. Examples of Level 1 assets are shares of corporations that are traded on stock markets and also debt securities such as bonds that are traded in a market. Of course, cash and cash equivalents fall into this category. The main point is that if these assets are offered to secure a bank loan, then their market values (as proxies for fair values) are easily observed. From a bank s perspective, Level 1 assets are the best form of collateral commitment by an SME. Level 2 assets are transacted between parties quite infrequently and so do not have consensus market prices as is the case for Level 1 assets. The value of the asset is typically estimated or appraised using a model. Simply put, Level 2 assets do not have observable prices, but data is available as input to a model to calculate a price. This is sometimes called mark-to-model. A classic example of a Level 2 asset is real estate. Level 2 assets are not typically traded in an open market on a regular basis and are normally estimated through a recognised model using observable input data. * See Financial Accounting Standards Board (FASB) 157. Retail Banking Academy,

17 Level 3 assets are extremely illiquid and the market price is practically based on in-house opinion or estimates. Examples include inventory, accounts receivable etc. The typical collateral assets of an SME are inventory, accounts receivable and real estate, which are Level 2 and Level 3 assets for which estimates of their respective market values are quite difficult to obtain with a high degree of confidence. There is a lot of estimation work so reliable values are not assured. Banks prefer liquid collateral (i.e. Level 1 assets) since, should it become necessary to reclaim the funds borrowed, they can sell it relatively easily in an open market. It is no wonder that in times of severe economic distress, banks seek Level 1assets as collateral. The difficulty for borrowers is that this is precisely when they have less Level 1 assets and a preponderance of Level 2 and 3 assets. The Role of Prudent Haircuts While liquid collateral gives the bank an opportunity to sell the asset without undue delay, haircuts lower credit risk to the bank. Indeed, haircuts are determined by the expected future price volatility of the collateral asset and hence the degree of uncertainty about the true value of the asset. For this reason, Level 3 assets will typically be subject to a significantly higher haircut relative to Level 1 assets. We summarise some key points on non-price terms and conditions in the box below: * The size of the haircut on collateral assets for SMEs is typically high since collateral assets are normally in the category of Level 2 and Level 3.The actual value imposed by a bank will depend on local market conditions since only Level 1 assets are typically traded on liquid markets. Simply put, the size of a haircut to collateral is determined individually and not nationally, except for Level 1 assets. The literature on SME lending has found some interesting relationships on non-price terms and conditions. a) A borrower is less likely to default when the collateral value far exceeds the loan amount. The borrower is likely to repay the loan and free-up the collateral. This assertion is quite interesting in relation to the calculation of the markup of credit risk. A high haircut implies a low loan-to-value (LTV) and hence less credit risk for the bank. This also implies a lower markup for credit risk. b) Conventional wisdom states that loans backed mainly by Level 1 assets are less risky and tend to earn lower loan rates. c) Loan size and collateral requirement are directly related. For example, Jackson and Kronman* conclude that larger loans should be more frequently secured. It is clear from the equation above, that the size of the loan is positively related to the collateral commitment. d) Some authors also assert that loan size is linked to the probability of default by the borrower, since a firm that receives a large amount of debt attains a higher leverage level which increases the risk of non-payment. This point was raised by Avery et al., amongst others. This assertion implies that the SME s level of new debt may increase the customer s level of leverage, which can increase the financial risk of the customer. Hence, the risk manager can manage the markup for credit risk by restricting the loan size so that the customers debt-to-equity ratio is not inordinately high. * Thomas H. Jackson and Anthony T. Kronman, Secured Financing and Priorities among Creditors, The Yale Law Journal, 88, , (1979). 66

18 * Lazy Bank Hypothesis Manove, Padilla and Pagano define a bank (specifically the loan officer) as lazy if it voluntarily chooses prospective borrowers who commit to a high level of collateral but without conducting effective customer screening as prescribed in Chapter 1. By this action, the provision of high quality collateral is viewed by the loan officer as a substitute for effective screening. Accordingly, loan officers who accept loans on the basis of collateral requirements increase the risk of adverse selection the risk of choosing the wrong loan applicant. The lesson is clear the screening stage of the lending process is an absolutely necessary step in that process. Collateral commitments alone are not substitutes for an efficient three-stage lending process. An assessment of the customer s willingness and ability to repay the loan obligations is crucial. Bank-Customer Relationship There is evidence that the quality and duration of the bank-customer relationship is an important determinant of collateral requirement by the bank. Specifically, customers with a longer relationship with their bank incur a lower incidence of collateral (i.e. may even obtain collateralfree loans). This evidence is provided by, for example, Harhoff and Korting. The rationale is quite clear. An SME with a longer relationship with the bank provides the latter with important information regarding the SME s willingness and ability to repay loan obligations. The degree of information asymmetry (where the bank is at an informational disadvantage) is reduced and so the role of collateral in limiting credit risk and moral hazard is of less importance. Accordingly, the bank may require a reduced level of collateral or may even offer collateral-free loans. The duration of the bank-customer relationship is negatively related to the level of collateral required by the bank. The longer the duration of the bank-customer relationship, the lower the level of collateral required by the bank since the credit risk is better judged from the increased transparency. At this point, we see that loan size and collateral requirement are positively related with the maximum loan amount determined after applying a haircut to the market value of the collateral asset. We now consider the role of the duration of the loan in controlling and monitoring credit risk for the bank. Duration of Loan (or Time to Maturity) It is clear that loans with a long maturity require that loan officers make a similarly long-term judgment of the creditworthiness of the loan applicant. Obviously, an SME that is deemed to be creditworthy at the time the credit decision is made will not necessarily be creditworthy in the future. And the likelihood of this being the case increases with a longer term for the loan. Indeed, banks will be less willing to grant loans with a long maturity to riskier SMEs or to offer unsecured lending. As we discussed in Chapter 1, the chance of occurrence of an adverse economic event (Conditions in the 5Cs paradigm) looms larger when the duration of the loan is longer. In this case, the provision of collateral by the loan applicant has the power to decrease this source of credit risk and so reduce the markup for credit risk. For this reason, bank loans to SMEs are likely to have a relatively shorter time to maturity. This feature of loans to SMEs coupled with loan covenants are likely to address the issues arising from information asymmetry. * R.B. Avery, R.W. Bostic, and K.A. Samolyk, The role of personal wealth in small business governance Journal of Banking and Finance, 22, (1998). M. Manove, A. J. Padilla and M. Pagano, Collateral versus Project Screening: A Model of Lazy Banks, Rand Journal of Economics, 32(4), (2001). Dietmar Harhoff and Tim Korting, Lending Relationships in Germany: Empirical Results from Survey Data, CEPR Discussion Papers 1917 (1998). Retail Banking Academy,

19 Loan Covenants Covenants are financial or operating conditions imposed by the bank in the loan contract that serve to protect the interests of the lender. Paglia * indicates that covenants place requirements and/or restrictions to constrain the SME s ability to undertake activities that are potentially harmful to the interests of the bank. Hence, covenants provide control and flexibility in the monitoring stage of the lending process and, if the borrower violates these covenants, lenders may require that the outstanding principal become due immediately or it may trigger an increase in interest rates on the loan. A key rationale for the inclusion of loan covenants is that if they are violated, banks have the opportunity to react before the borrowing firm actually defaults on its loan. This is an important point since actual default may lead to a significant credit loss for the bank. In fact, violation of loan covenants by the SME gives the bank an opportunity to restructure the loan. Loan covenants are generally classified as financial and non-financial. Financial covenants place restrictions on the SME s accounting ratios such as debt-to-equity, total debt service ratio (TDSR) and interest coverage ratio (ICR). As pointed out by Mather and Peirson, financial covenants are defined as covenants that use accounting data in their formulation either as an absolute amount or as a ratio. Non-financial covenants can include restrictions on asset sales, forbidding additional encumbrances on committed collateral, description of uses of the loan, agreed to business activities or a requirement for periodic financial reporting. Clearly, as asserted by Berger and Udell, financial covenants are likely difficult to enforce for SMEs with unaudited and highly opaque financial statements. This places added emphasis on the bank s monitoring of non-financial covenants after the loan is granted. What is the main lesson? In order to facilitate effective monitoring, it is advisable that lenders in the contracting stage, seek collateral commitments with conservative haircuts especially for Level 2 and 3 assets; issue loans with relatively short maturity to minimise the effects of potential adverse economic events; and include in the loan contract effective non-financial covenants which provide restrictions and early warning signals for the bank. These all have the effect of reducing the markup for credit risk We now deal with determinants of the markup for liquidity risk and markup for optionality. Markup for Liquidity Risk The Basel Committee on Banking Supervision (BCBS), reported that many of the fundamental principles of liquidity risk management were neglected by banks during the recent financial crisis. Banks must now include a markup for liquidity risk especially for long-term loans. Table 3 of a research paper published by the Bank for International Settlements reveals a typical relationship between term liquidity premium ** and loan maturity in years. Here is a copy of this * John K. Paglia, An Overview of Financial Covenants in Commercial Bank Loans, The Risk Management Association (RMA) Journal, (July 2007). Paul Mather, and Graham Peirson, Financial covenants in the markets for public and private debt, Accounting and Finance, Vol.46 Issue 2 (2006). A.N. Berger and G.F. Udell, The economics of small business finance: The roles of private equity and debt markets in the financial growth cycle, Journal of Banking & Finance, 22(6-8): (1998). Refer to Liquidity Risk: Management and Supervisory Challenges, BCBS, (February 2008). See Joel Grant, Occasional Paper No.10, Liquidity transfer pricing: a guide to better practice BIS. Bank for International Settlements Web. < ** The method for the calculation of the term liquidity premium is relatively complex. Details of this method 68

20 table in part: Maturity of Loan Term Liquidity Premium (basis points) Clearly, the markup for liquidity risk increases non-linearly with the time to maturity of the loan and the precise size of the markup depends on the outstanding maturity of the loan and financial market circumstances. Hence, by issuing loans with a shorter time to maturity, the risk manager can lower the markup for liquidity risk. It is noteworthy that as the term to maturity of the loan increases not only does the liquidity markup increase but also, all else being equal, credit risk increases since the likelihood of default increases for long-term loans. This shows an inherent link between liquidity risk and credit risk with the term to maturity of loans. Markup for Optionality Prepayment risk is an important consideration in the pricing of commercial mortgage loans. This risk arises from an unexpected lower return of the outstanding loan obligations to the bank when the SME borrower refinances the loan or prepays. The literature on prepayment optionality on loans shows that prepayment risk may significantly impact the return on loans, return on equity and real estate loans to total loans ratios of various commercial banks. * One of the reasons for this result is that a significant reduction in market interest rates relative to the contractually fixed rate mortgage rate increases the likelihood that the SME borrower will exercise the option to prepay. In this case, banks cannot earn the interest income they intended to earn when the original mortgages were created. Accordingly, banks face reinvestment rate risk. It is conventional wisdom that the higher the loan-to-value (LTV) ratio (i.e. the higher the leverage), the greater is the debt service requirement, which likely negatively affects the borrower s ability to repay the loan obligation. Indeed LTV and debt service ratios (DSR) affect default risk of mortgages to SMEs. But there should be caution in making a strong conclusion. An SME may have a high LTV but if there are other favourable conditions such as a strong positive cash flow, the link between LTV and default risk may be less pronounced. Lesson Banks may manage the markup for optionality risk by limiting loan maturity (so that interest rate volatility is expected to be lower). In addition, a charge at the time of prepayment may act as a deterrent for the borrower to prepay. In summary, there are actions that the bank can take to lower the respective markups for credit risk, liquidity risk and optionality risk. In this way, the bank can charge a loan rate that is competitive and not deviate substantially from the loan standard conditions. So far we have described the three-stage lending process for collateralised loans. In practice, this applies to both short-term and long-term lending to SMEs by banks. But banks also issue unsecured loans to SMEs. Hence, we complete this chapter with a consideration of unsecured (i.e. collateral-free) loans. Unsecured Loans a Consideration of Information-Based Lending Banks have become more willing to provide unsecured loans to SMEs. Here are some recent examples: are found in Chapter 7 of Leonard Matz and Peter Neu, Liquidity Risk, Measurement and Management: A practitioner s guide to global best practices (Wiley Finance, 2007). * Alex Fayman and Ling T. He, Prepayment risk and bank performance, The Journal of Risk Finance, Vol. 12 Issue 1, pp (2011). Retail Banking Academy,