How Banks Limit Underwriting Risk in Commercial Lending
This won’t come as a surprising statement, but in commercial banking there is a tremendous amount of financial risk. It just comes with the territory. The trick to successfully managing risk and approving scenarios that can ultimately be beneficial for all of the involved parties is to address these risks head on. There are many ways that banks measure risks and make informed decisions to minimize their exposure to any potential losses, while also setting up their customers for success.
But first, let’s define the term: What is risk underwriting?
Basically, risk underwriting occurs with the careful and thoughtful development of a process, followed by its effective execution. In banking, the idea is to minimize exposure to losses while also protecting the value of an asset. Many risks can be managed with a good game plan, and a good game plan has several key aspects.
Ways Commercial Banks Address Risk Underwriting
As for what risk underwriting in banking looks like in action, there are some basic things that banks carefully study before entering into a potentially risky venture. Generally speaking, the five Cs of credit – or the leading factors that play into a borrower’s credit – are given a lot of weight. Those five Cs are Cashflow, Character, Conditions, Collateral, and Capacity. Let’s look at each of those five factors, as well as a couple more insights, below:
1. Strong Cashflow: EBITDA to Annual Debt Service Ratio
The first box for a bank to check in a risk underwriting evaluation is simple enough; can the borrower repay the loan? This can be determined by evaluating the borrower’s cashflow. Banks look for a strong cashflow and then check the ratio of the borrower’s EBITDA (earnings before interest tax depreciation and amortization) to the annual debt service. This simple formula can help demonstrate whether or not the borrower has the ability to repay the loan. The bigger the cushion, the more comfort that a bank has that the borrower can work through a softening in business or an unexpected scenario, like an increase in interest rates.
2. Strong Balance Sheet: a D/NW < 2 or 2.5:1
Another factor that plays into risk underwriting is a glance at the company balance sheet. This plays into the capacity theme of the five Cs of credit. Like strong cashflow, having a robust balance sheet can give a bank the assurance it needs, especially when looking for multiple repayment sources. An example of a strong balance sheet is one that has a D/NW ratio of less than 2 -2.5 to 1. In layman’s terms, that means for every $2-2.5 in liability a company has, the ownership has $1 of equity in the company. This means the company would have equity in assets that could be sold or financed to pay back the bank loan if the primary source of repayment – the cashflow – fails.
3. Equity in Collateral
Having collateral, or something that hangs in the balance as security for the loan, can also play into common risk underwriting techniques. However, it’s not in the bank’s interest to take the collateral, unless all the other forms of repayment fall through. Banks don’t leverage 100% of the value because then, the borrower will have less incentive to pay back the loan. So, there should be some equity in the collateral, so the bank can be certain that the borrower has skin in the game, so to speak.
4. Liquidity
We’ve all heard the phrase “Cash is king.” This is something that banks believe as well, especially in risk underwriting. It is greatly assuring for a bank to see that a borrower and/or a guarantor has some liquid resources. This shows the borrower can be sustainable through a temporary rough patch, should any occur. This can also be shown with a properly-sized down payment on any loan – or capital.
5. Good Credit
As with all loans, having good or excellent credit is vital for a bank to feel confident that risk is being managed and mitigated. This is how banks measure a borrower’s Character, by evaluating their credit history. Commercial borrowers need to have a track record of honoring financial obligations. At a minimum, the credit score for a commercial borrower should be above 660. Of course, the higher the score, the better a bank can feel about any risk. Scoring above 700 can give a borrower a much better chance of approval. A score of 750 or above is considered excellent.