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Business Borrowing 101 ... from your banker's point of view - Part 3: The Business of Banking

by Mr. Mike Sanders

 

Part 1 | Part 2 | Part 3 | Part 4

This article is a 4-part series. Click PART TWO to go back and read prior part.

 

"John, I have joined Dad's company. We want to modernize our equipment so that we can improve production and add a new product line. I figure that we need to spend $500,000 and hire a few new employees. I have visited with our local banker. He doesn't seem overly excited about our request. Can you give me a little insight as to what he might be thinking and what I might do to enhance our odds of securing this loan?"

John was happy to be of assistance with your inquiry, offering you a crash course in Loans 101 from a banker's point of view. First, he says, "Let me assure you that bankers need to make loans - as loan interest is the primary source of income for the bank. Loan accounts are viewed as assets for the bank and deposit accounts are the bank's liabilities, which is the exact opposite point of view from the customer's prospective. The bank needs the loan income to pay interest on the deposits plus cover all other operating expenses of the bank and provide a return for the shareholders of the bank's stock. The decision is not ‘to lend' or ‘not to lend,' but which loans to make.

Credit Risk

"Initially, we analyze the ‘credit risk'. That is to say, what are the chances of having the loan repaid through the normal course of the business' operations? Bankers assess the business plan with regards to the character, cash flow and collateral of the borrower. This is called the three C's of credit.

"If the borrower is not of good character, we probably should not want to do business with them. First hand knowledge, references and credit reports are some of the tools used to measure character. After that, we look at the borrower's ability to generate sufficient cash flow to meet the terms of the loan on an orderly basis. But, we also look at the global cash flow and debt service requirements to get an overall evaluation of the borrower's cash needs to meet all obligations. Last, we look at collateral to secure the loan. The bank never wants to be in a position of having to depend on the liquidation of the collateral to repay the loan, but in the worst case situation, that could happen. Nobody pays retail on foreclosed collateral from the bank.

"Remember, the bank is not assuming a partnership role with the borrower; we are the lender. The bank's goal is a return OF the asset first and a return ON the asset second. Think of the bank like a car rental agency. The car rental transaction makes sure that you have a license and insurance first and then rents you a car. They always want the whole car back with all fenders intact plus they want their rental fee for your usage of the car.

Interest Rate Risk

"The bank is no different, asking 'Who should we 'rent' our money to?' Then, we want all of it back and some income on the 'rental' of the funds. The upside for the bank is the interest and fees on the loan. The potential down side is interest, fees and principle. So, on your $500,000 loan if the rate was 7% and you had a 1% loan origination fee, the most the bank could make in one year was $40,000 and the most they could lose is $540,000. On the other hand, there in no limit as to how much a borrower could make with their loan proceeds. It all depends on what you do with the loan proceeds.

That is why most bankers seem a little less enthusiastic than our customers. "The next consideration of the banker is interest rate risk. That is to say how do we structure the pricing of the loan? Since loans continue over a period of time and the cost of funds to the bank varies with that period, how does the bank hedge that exposure? Most customers would like to know specifically what their loan payment will be over the life of the loan. They would like to ‘fix' or lock in the interest rate. So, on your equipment loan if you want ten years to pay it off, you might want a fixed rate for that ten year period. The problem is that the market forces on interest rates are not likely to be static for that ten years. The interest rate or cost that the bank will have to pay to get deposits over the same ten year period to fund your loan will probably fluctuate. If the bank's cost of funds goes down during the period, we make more on the loan due to increased margins. On the other hand, if rates go up, the margins shrink and in a worst case situation, the bank could be collecting less than it is obligated to pay to the depositors. That's what bankrupted the savings and loan industry back in the 1980's. The S & L's made fixed rate long-term home mortgages that they tried to fund with shorter term deposits whose costs rose past the mortgage income rate.

Lenders always lose with fixed rates. "If underlying rates increase, the bank's margins (profits) go down. Oddly enough, borrowers never come in and offer to pay a higher rate. Conversely, if rates decline during the term of a fixed rate loan, many times the customer will pressure the bank to lower the rate or he will move the loan to another bank at the prevailing lower market rate. Most bankers would prefer that their loans have an interest rate that follows market conditions.

"This is called a floating or variable rate loan. The banker and the customer would agree on a relationship to the "Prime" rate of interest, say prime plus 1.5%, and then adjust the interest rate to those terms periodically throughout the life of the loan. For example a rate adjustment could be made every year. This allows both parties to share the risk of interest rate fluctuations. Most bankers will price the loan more cheaply if they do not have to bear the full burden of rate risk.

Allocation Risk

"Last, the banker will evaluate the allocation risk. He must be mindful of not putting too many eggs in one basket. Bank regulators measure concentrations of credit. That is having too large a portion of loans to one industry, or individual or geographic area. We saw what happened to the Enron employees that had all their retirement accounts in Enron stock. That same principle applies to a bank's loan portfolio. Allocation also applies to who gets the bank's loan funds. If the bank only has so much money to lend, then they must allocate those funds in a manner that gets them the best return on that investment. If credit and interest rate risks are equal, the allocation decision will be based on yield or return on the loan. Yield is impacted by interest rate, fees, interest payment structure, account balances with the bank and other products and services that the borrower might have from the bank. This is not unlike your customer that buys the most golf clubs getting the best price and delivery schedule. Or the customer that needs an order ASAP and is willing to pay whatever it takes to get it handled.

"John, I never thought about this loan from the banker's point of view. So what would your advice be on how to proceed and structure my request? What would give me the best chance to obtain the funds we need?"

Part 1 | Part 2 | Part 3 | Part 4

Please select PART FOUR to continue with our unfolding story and training for Business Borrowing 101 ... From Your Banker' Point of View.

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About the author

Mr. Mike Sanders

Mr. Mike Sanders (USA)

Mr. Mike Sanders holds a BBA in Finance and an MBA. He is a licensed real estate broker and a 35+ year career banker.

 

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