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Sin of loan risk isn’t the risk

4 ways you may be fooling yourself

Sin of loan risk isn’t the risk

Recent reports that business loan demand is increasing seem encouraging. Banks, large and small, are opening up the credit spigot a bit wider.

Yet I wonder how much of this newfound demand comes from improved underlying business conditions … and how much might be banks simply willing to compromise standards to generate additional interest income.

Grounds for worrying

Anecdotal evidence aplenty indicates that banks became more conservative in the few years following the credit panic of 2008. Some relaxation of caution is in order—and maybe it’s occurring in measurable ways.

There’s also the possibility that following an extended period of suppressed loan demand, a considerable number of banks are deliberately trying to stimulate more commercial loan business. There are two ways of going about this:

• Increase the supply of credit to encourage business owners to get off the sidelines.

• Compete against in-market lenders for a finite and still relatively shallow pool of “bankable” credits.

The latter course requires salesmanship. But it also means competing on credit terms.

The risk here is that credit standards slip, and collectively the industry tends to reach for the lowest common denominator. This is the nature of competition in a market characterized by an abundance of supply but a paucity of demand. The borrower wants more favorable terms—while the lender is anxious to boost his bank’s interest income.

“What’s wrong with risk?” you might ask? 

“Nothing” is the appropriate answer. But with the caveat that you fully understand what risks you’re taking on.

Higher risks=higher rates, for a reason

Commercial finance-type loans as a product line—loans to borrowers secured by inventory, receivables, and equipment with high advance ratios on collateral and  relatively thin balance sheet equity cushions—are riskier business than a general portfolio of business credit reflecting a variety of purposes and formats.

Consumer finance is a different world from most commercial credit. It’s usually quite labor intensive. Lenders invariably have considerable experience in administering this sort of credit. It’s no place for the novice.

Both sorts of loans bear a higher rate of interest. But remember, that difference compensates for the higher costs of administration required to bring the credit risk level to within acceptable tolerances. The trade-off is clear and quantifiable.

Many banks seem to be competing recently on more limber terms of credit and where the trade-offs between reasonable credit risk and excessive credit risk reside are less clear and where the risks are less quantifiable.

4 ways you may be kidding yourself

Consider some of the principal weapons by which these competitive skirmishes are waged:

1. Covenants. These are the constraints we place on the borrower. They often result in lower levels of risk and/or shorter response times within which we can take corrective action.

These are becoming more lenient.

2. Personal guaranties. There used to be an almost universal standard requiring guaranties of all loans to closely held businesses by their principals. They were also typically joint and several and were not limited or circumscribed in any way.

Fewer loans today carry the unlimited guaranties of the principals.

3. Collateral advance ratios. These are a way of enhancing the equity that the borrower has in the deal. Equity is a buffer against loss. It doesn’t necessarily have to reside in an exclusive calculation of the debt-to-equity proportions on the borrowers’ balance sheet.

Advance ratios are becoming more aggressive (lenient). Leverage is increasing but through the back door.

4. Rate and contractual maturity. The longer the maturity, the less willing a lender traditionally has been to agree to a fixed rate. The lack of a variable rate, coupled with a longer duration, creates a larger interest rate gap. Therefore, this results in higher levels of liquidity risk and market risk.

Examiners have issued numerous warnings in the last year or two on the subject of concessionary pricing. Clearly, they grow concerned at what they see at some banks.

Mission Possible? To enumerate total risk?

The problem from the lenders’ point of view is that it’s often virtually impossible to quantify the risk that is being assumed.

• Does a personal guaranty make a credit automatically stronger? 

• Does less equity in collateral advance ratios result in more credit risk? 

• Does a fixed-rate loan at prime with a maturity of five years create an unnecessary level of interest rate risk in an environment of impending rate increases? 

There is no necessarily right or wrong answer to any of these questions.

But I think the real questions are the ones that the examiners have been posing for the last few years:

• What is the overall direction of credit risk? 

• Is it increasing, decreasing, or stable? 

We seem to know what they think.

What do you think?

Pricing for risk—belief and reality

Unlike a loan product that is labor intensive to service and supervise, there’s nothing readily quantifiable about any of these “soft” risk categories. But are we as an industry pricing for credit risk?

I think that anyone who thinks that we are doing this in any sort of scientific, quantifiable way is kidding himself.

We are frequently making our portfolios riskier and taking our comfort in pricing an extra quarter or half point into the rate (assuming that we can get it).

But truly pricing for risk implies that we know what the risks are.

Instead of imprecise estimates of risk and building a nominal “SWAG”* risk premium into the rate, we should allocate additional resources into the process of more diligent monitoring of each loan account.

This means during the life of any loan of significant size, our banks should perform periodic look ins, insist on receiving and analyzing periodic financial statements, track covenant performance, and be aware in a more than just casual way of the financial performance of the borrower.

And all of this gets paid for through a higher rate.

Many banks do this, of course, as a matter of routine.

Yet why did so much credit risk, so evident in hindsight, slip by us as an industry in recent years? 

What are we doing about it today while it can still make a difference in our collective results a year or two down the road?

There’s nothing wrong with risk per se.

Our sin is in not recognizing it.

* SWAG stands for the scientific “sorta wild-ass guess” methodology.

Ed O’Leary

Banking Exchange Contributing Editor Ed O'Leary, a veteran lender and workout expert, spent nearly 50 years in bank commercial credit and related functions, working with both major banks as well as community banking institutions. His last job before retiring was as the CEO of a regional bank headquartered in Alburquerque, N.M. He earned his workout spurs in the dark days of the 1980s and early 1990s in both oil patch and commercial real estate lending. O'Leary began his banking career at The Bank of New York in 1964, and worked at banks in Florida, Texas, Oklahoma, and New Mexico. He served as a faculty member and thesis advisor at ABA's Stonier Graduate School of Banking for more than two decades, and served as long as a faculty member for ABA's undergraduate and graduate commercial lending schools. Today he works as a consultant and expert witness, and serves as instructor for ABA e-learning courses. You can e-mail him at [email protected]. O'Leary's website can be found at

In mid-2016 O'Leary's "Talking Credit" blog received a bronze excellence award for the Northeastern Region from the American Society of Business Publication Editors.

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