Bankers Urged to Get to Know Borrowers

Regulators want the nation’s banks to get to know their small business customers better. In a statement Friday, federal and state regulators said banks shouldn’t curtail credit based on negative trends in an industry or location. Instead, they should evaluate each business on its own ability to repay. From the statement (emphasis mine):

An institution should understand the long-term viability of the borrower’s business, and focus on the strength of a borrower’s business plan, including its plan for the use and repayment of borrowed funds. The institution should have an understanding of the competition and local market conditions affecting the borrower’s business and should not base lending decisions solely on national market trends when local conditions may be more favorable. Further, while the regulators expect institutions to effectively monitor and manage credit concentrations, institutions should not automatically refuse credit to sound borrowers because of a borrower’s particular industry or geographic location. To the maximum extent possible, loan decisions should be made based on the creditworthiness of the individual borrower, consistent with prudent management of credit concentrations.

Further, institutions should promote a credit culture in which lenders develop and maintain prudent lending relationships and knowledge of borrowers. This culture should encourage lending staff to use sound judgment during the underwriting process. While institutions may use models to identify and manage concentration risk, portfolio management models that rely primarily on general inputs, such as geographic location and industry, should not be used as a substitute for the evaluation of an individual customer’s repayment capacity.

Banks have been pulled in two directions over commercial lending. The Obama Administration and members of Congress have urged them to expand lending to small businesses, but regulators want them to reduce their risk. In this statement, the regulators say they won’t penalize banks for making loans to businesses in troubled industries or locations, as long as the bank has soundly assessed the borrower’s ability to repay.

As a general principle, examiners will not adversely classify loans solely due to a decline in the collateral value below the loan balance, provided the borrower has the willingness and ability to repay the loan according to reasonable terms. In addition, examiners will not classify loans due solely to the borrower’s association with a particular industry or geographic location that is experiencing financial difficulties.

Large banks have increasingly favored credit scoring and computer models over the “relationship lending” characteristic of community banks. Manufacturers in Michigan or builders in Nevada look risky to automated models. But even in shrinking markets, some businesses are growing (possibly gaining share as competitors go under). Relationship lending is more time-consuming, and thus more expensive for smaller loans.

In this statement, regulators are asking all banks to act a little more like local lenders. “The community banks are small enough that they know what’s happening in their local marketplaces, so it’s easier for them to look at that business and not have a problem making a loan that another bank might pass up,” says Sam Thacker, a former commercial loan officer and a partner at Austin-based Business Finance Solutions, which helps small businesses obtain financing.

Thacker told me that with the exception of Wells Fargo, most of the large banks aren’t equipped to evaluate small business loans with such attention. He says he doesn’t even know if some national banks have commercial loan officers in Austin, a metro area of 1.7 million people.

It’s not clear whether the regulators’ prodding will make big banks take a cue from their smaller counterparts. Thacker says it would be a good idea. “I am a proponent of small business being looked at on a holistic basis,” he says. “The bank might need to look at the credit report of the owner of the small business, but they don’t necessarily have to make the decisions to loan on the basis of credit score.”

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