Earlier this year we discussed prospect screening. A good screening process will help to weed out prospective Borrowers that don’t fit your institution’s credit risk profile. But, these processes aren’t perfect. How can declining a commercial loan be supported with an objective rationale? Here is how we handled a recent decline decision for one of our clients.
Declining a commercial loan-objective vs. subjective rationale
In our experience, we have come across lending professionals will all kinds of biases against one industry or another. A common bias we have encountered is general contractors. More than one credit professional has expressed their disdain for these borrowers without having set eyes upon the credit. Their prior experience with borrowers in this industry was negative. Therefore, the presumption is the loan will default no matter what the credit risk profile is of any GC. This is very clearly a subjective rationale for not approving a loan.
What about a more objective rationale for declining a commercial loan? What would that look like? Quantitative facts and qualitative rationale, supported with subjective assumptions, are a great way to build an objective rationale for declining a commercial loan. How did we demonstrate an objective rationale for a recent decline decision? We used questions surrounding the capacity, collateral and cash flow to justify the decline decision.
A marketing firm approached one of our clients with a working capital line of credit request. The potential Borrower had several years of experience assisting other businesses with brand-awareness campaigns. The prospect was provisionally awarded a multi-year, multi-million dollar state contract. The contract required the Borrower to operate an after-school program. Once we read the business plan we noticed several things that gave us pause. First, the business plan did not address the gap between the owner’s educational and professional experience relative to running an after-school program. Second, the business plan did not provide details regarding a curriculum or staffing plan that gave us a measure of confidence that the Borrower would be able to perform under the terms of the contract.
The Borrower’s business had no tangible assets. The provisional grant award and associated state contract could not be pledged as collateral for a loan. Furthermore, the contract could not be assigned. While the lack of collateral in and of itself was not a precursor for declining a loan, when combined with the other factors present as part of the credit risk profile the lack of collateral was a factor in the decision to decline the loan.
Unsubstantiated forecasted cash flow
The projections depicted revenues from the contract of $135,000/year. The projections included additional revenues from unidentified projects. However, without these additional revenues there was not sufficient cash flow to pay down the line at the end of each school year. The Borrower was unable to substantiate the additional revenues depicted in the projections.
Documenting the decline decision
Based upon our analysis we felt the loan did not meet the credit risk profile the Lender had established for commercial borrowers. First, management did not establish they had the operational capacity to perform under the terms of the grant. Second, the loan was going to be under collateralized. Finally, there was no quantitative support for the cash flow projections. Each of these three reasons both together and separately were objective reasons supporting a decline decision for this particular commercial loan. Critically, the Lender was provided with an objective analysis that clearly outlined the rationale for declining this loan. The Lender provided the Borrower with support for the loan decision that was based upon facts and not personal or institutional biases.