The Cs of Credit

By Robert J. Hogan

The accounting profession has Nine Governing Principles, the legal world has Two Ruling Laws, and commercial banking has 5 Cs of Credit. All these dictate a culture, a train of thought or a logical view of their respective professions. In banking whether you’re a trainee, a junior lender or a seasoned professional; the 5 Cs of credit serve as a lead chapter in the industry’s banking bible. For years the traditional 5 Cs of Credit have been the ruling doctrine for granting credit; they represent the foundation of fundamental credit analysis and frame the credit decision making process. The Cs of Credit help lenders transition from financial analysis to credit analysis, they help lenders examine the big picture, and they put the credit request in the right context. The 5 Cs of Credit are; capacity, character, collateral, capital and conditions. The following examines each C of Credit, and defines what lenders are evaluating in a pending credit request:

Capacity examines whether the borrower has the capacity or ability to repay. This is the most important and defining C of Credit. According to federal statues the ability to repay is supposed to be from the self-liquidating operations of the credit, i.e. from normal business operations. The question is whether or not the business can generate the cash flow required to service the debt. The cash flow needs to be sufficient to provide the lender with a cushion; generally referred to as a minimum debt-service-coverage (DSCR). In most institutions this runs somewhere between 1.2 and 1.4. The most common DSCR is 1.25 which means for every $1.00 of debt service (paying back interest + principal) the business needs to generate $1.25 of cash flow. From this professional’s point of view, nothing trumps cash flow’s ability to service debt. In our commercial lending school this statement cannot be stated too often, “If the cash don’t flow, the loan do go.”

Character examines whether the borrower demonstrates a willingness, or has a track record of a willingness to repay. This is probably the 2nd most important C. It measures whether the borrower stands behind their commitment to repay. Are they good for it? The banking industry was founded on the good faith of a handshake; as people stood behind their word, as it represented who they were, it defined them. Unfortunately, today’s world is a little more complex and sometimes unforeseen things happen.

As lenders we need to know whether the borrower we’re dealing with stands behind their commitment. Do they have the determination to pay us back? Lenders today rely on credit reports, credit scores, your reputation, and their own experience with the borrower to help them establish character.

Collateral is the secondary source of repayment; it pledges other assets against the loan in case the primary source of repayment (cash flow) fails. Sound credit policies and procedures require all loans to have a secondary source of repayment; a back-up plan to minimize the risk. Collateral supplies a lender with that back-up plan or a sense of security. In banking, when there is too much pressure being put on booking loans, there can be an over reliance on collateral. There is a mentality that states, “If you got the dirt, you can’t get hurt.” For commercial loans the most common form of collateral is real estate; there is something about the security of a commercial building. However, from a lender’s perspective the question always needs to be, “How are you going to convert the collateral to a source of cash flow?” So, there will always be two issues associated with any collateral; 1) How are you going to get legal and physical possession, and 2) How are you going to convert the collateral to cash?

Capital measures the risk in the credit request. The ultimate question is whether the borrower has any skin in the game or not. As a financial institution for a return, you are only going to get Prime + 2.0% period, as such, you should not be taking on all the risk. The borrower needs to have something at stake, they need to lose something if the transaction falls through. Most financial institutions today will accept a maximum debt to equity of 3.0 to 1.0; which means if your borrower has $100,000 of equity, the maximum outstanding debt they can have is $300,000. Given today’s regulatory environment the importance of this C is right up there. Financial institutions aren’t going to take on excessive risk. They simply aren’t going to do it.

Conditions measure outside forces, and the probability of whether or not we’re going to get repaid. It examines the state of the economy on a national and local basis. It examines the borrower’s industry and the condition of the business itself. And it evaluates and predicts the likelihood of whether or not the business can generate the cash flow required to service debt at a predetermined level. Conditions is the process of the lender stepping back; examining the big picture, and examining the context of the credit request.

The previously mentioned 5 Cs of Credit have admirably served the banking industry for years. When consistently followed, these 5 Cs have built a solid umbrella over the credit decision making process. At Hipereon, Inc. we acknowledge the applicability and sustainability of the traditional 5 Cs, however, we believe the Cs of Credit need to be brought into the 21st century. We believe they should be expanded to 8 Cs. We believe today’s; regulatory environment, market risks, and economic pressures justifies having 8 Cs of Credit. Our proposed 3 additional Cs are:

Compliance measures whether or not the credit request is in compliance with federal/state regulations, and is consistent with the institution’s business plan. Even if it complies with regulatory statues, is it something the financial institution strategically wants? It the credit request one we’re looking for, or is it one we’re reacting to? Did the institution go after it, or did the request seek us out? As a financial institution we need to be strategically focused; we need to know who we want to serve, what we want to offer, and how we’re going to deliver.

Cost-benefit measures whether or not the institution is being adequately compensated for the contemplated risk? Are we risk based pricing? Did we price the request competitively, or did we price the request to get the deal? As a financial institution, are we adding value to the transaction to justify the price, or are we being the cheapest deal in town and trying to match the competition. At Hipereon, Inc. we don’t subscribe to being the cheapest, or being the easiest business model. We believe financial institutions should price for the risks associated with the credit request.

Caring evaluates whether the lender or the institution is committed or not. The question is; “Is this an industry sector, Is this an individual, and Is this a credit type that we care about?” Does the lender and/or the institution have an affinity for this type of credit? Do we have expertise in this area, and is it something we’re interested in?

Incorporating the Cs of Credit into your credit decision making process will enhance your institution’s credit portfolio. There are no guarantees in business banking, all we can hope for, is to increase our odds of getting repaid. In your credit underwriting process; whether you use the traditional 5 Cs of Credit or Hipereon’s proposed 8 Cs of Credit you’ll be taking a step in the right direction.