"The main reason people struggle financially is because they spent years in school but learned nothing about money. The result is, people learn to work for money... but never learn to have money work for them." (From RD&PD)
The purpose of this article is to shed some light on how a bank evaluates a loan request from a potential borrower. But, before we get there, let’s have a quick review of how a bank works and who the key players are in the credit approval process.
In it’s simplest form, a bank makes money by taking funds in the form of low cost deposits (checking/savings/money market accounts) and then loaning out that same money at a higher interest rate. A bank’s profit is a result of the “spread” or the difference between the rate it pays for the deposits and the return that it makes on loans.
In order to protect the deposits entrusted to the bank, all loans go through a credit approval process. During this process a bank determines whether or not a proposed loan has a high enough chance of being repaid. If a commercial loan request doesn’t make the cut then it is denied or restructured to reduce the risk to the bank.
Key Players in the Credit Approval Process
When a potential borrower makes a request for a loan (in this case, we are going to assume that this is a commercial loan), there are many individuals involved in the decision to approve or deny the loan. Let’s take a look at the key players.
The sales manager is the individual who manages a team of commercial relationship managers. This is usually a senior person within the bank and one of the first people to see the loan request. Typically their involvement consists of a quick yes/no decision as to whether the loan request is one that the bank should pursue.
This is the “sales” person. Their primary responsibility is to bring new “relationships” to the bank, which includes both deposit and loan accounts. These are the people who are out actively calling on accounts, taking prospects to lunch, playing golf, and generally doing anything necessary to get the customer to move their banking relationship to whatever bank they represent. Most of the time, the loan request is brought into the bank through the relationship manager.
The credit officer is the individual with the authority to approve or deny the loan request. Each credit officer has a certain amount of “approval authority” indicating the maximum dollar amount that they are able to approve. Depending on the size of the loan request, the local credit officer may be able to approve it. If not, it may need to go to a more senior credit officer, or for the largest requests, to the bank’s credit committee.
This is the number cruncher. This individual analyzes all of the information gathered by the relationship manager and puts it in a loan approval document. This document outlines all of the risks and benefits of approving the loan and outlines the feasibility of repayment. When a loan is approved, this document is signed by both the relationship manager and the credit officer.
All of these individuals work together towards an approval decision on the loan. Now that we have an idea of the people involved in approving a loan, let’s take a look at the process.
How Loans are Made
The process begins when a relationship manager identifies a loan prospect and begins preliminary discussions with the customer about the loan. These discussions typically include the amount, term, and rate of the loan, generally speaking.
Next, the relationship manager presents the request to their sales manager (at small banks, there might not be a sales manager). They have a discussion about whether or not this is a customer that they would like to have. The relationship manager will leave this discussion with a directive as to proceed with the request or not.
If they get the go-ahead from the sales manager, they will go back to the customer and request several documents to use in evaluating the request. At a minimum, this usually includes: 2 years of tax returns for both the business and the individual, a personal financial statement, a current financial statement for the business (may be CPA prepared), accounts receivable listing (for commercial businesses), rent roll and proforma (for real estate), and any other documents that will support the loan request.
The relationship manager will take all of the above documentation and give it to the credit analyst. They will have a brief discussion regarding the proposed structure of the loan and the timing of the request.
The credit analyst will then begin their analysis, which takes the form of a loan approval document. Let’s take a look at the key components of a loan approval document, sometimes called a “Credit Memo” internally.
Summary of the Loan Request
The summary section of the credit memo provides a high level overview of the request, and will include the loan amount, loan term, proposed interest rate, individual/corporate guarantors, use of funds, etc.
Information About the Company
This section includes information on who the principals are, how much operating experience they have, how long the company has been in business, what the company does, etc.
The industry section includes information on what the prevailing trends in the industry are, how the subject company compares to other companies in their industry, what is the industry outlook is, etc.
This is the most important section. In this section, the credit analyst will take all of the financial data that they have received and make an attempt to estimate the company’s ability to repay the loan. This includes analyzing past data, looking at growth trends, industry trends, proposed loan terms, and certain assumptions that will get them to a number called the DSCR or Debt Service Coverage Ratio. The DSCR is the company’s free cash flow divided by the estimated debt service on the proposed loan. For a real estate loan, the process is the same, but the analyst will look at the cash flow generated by the property in question.
Company/Borrower Financial Analysis
This section will explore the financial statements of the proposed borrower. It will look at historical trends, critical ratios, and interim data to determine the financial health of the borrower.
Individual/Guarantor Financial Analysis
Many bank loans require the individual guarantee of the company principal(s). As such, an analysis is performed on each of the individuals who will be guaranteeing the loan, analyzing their ability to cover any shortfalls in the debt service should things not go as planned. The key here is guarantor liquidity or how much cash they have in the bank, and excess personal cash flow.
This analyzes the customer’s relationship with the bank. Are they a current customer? Do they have deposits? What other loans are outstanding?
Once the credit analyst has completed the loan approval document, they will give it to the relationship manager for proofreading. Typically there will be 2 or 3 rounds of edits including the proposed loan covenants and language in the document.
Final Credit/Loan Approval
Once the analyst and the relationship manager are satisfied with the contents of the loan approval document, they will present it to the credit officer for approval. Once again, there will likely be a few more rounds of edits to shape the deal into something that the credit officer is comfortable with. When the credit officer is comfortable with the terms, he will sign it along with the relationship manager.
Once the credit officer has approved the request, the relationship manager will send a term sheet to the borrower, outlining the bank approved structure of the proposed loan. The Borrower may attempt to negotiate certain points of the deal, but usually doesn’t have a lot of room to work with. If the Borrower accepts the terms of the loan, they will sign the term sheet and the bank will issue a commitment letter.
Once the term sheet has been signed and the bank has issued a commitment, the loan will be routed to either the bank’s internal loan operations area or to an attorney for the preparation of the loan documents.
After the loan documents are prepared and the borrower (or the borrower’s attorney) has reviewed them, the bank and the borrower will meet to sign them and the loan process is complete.