Ron Box
Ron Box

Your Bank: Under New Management

How bank credit risk can be managed.

May 5, 2011
by Ron Box, CPA, CFF

Many small to midsize businesses have one commercial banking relationship on which they depend for commercial checking, working capital and other types of credit. The head of finance at these organizations may have found this to be a relatively straightforward and direct way of doing business and therefore have no perceived reason to seek out more than one bank. However, this sense of security can prove to be very dangerous. Your firm's bank could be the target of a bank merger or the bank could fail, requiring a regulatory agency to broker a deal. Either way, you may find yourself in a strange new banking world with new rules and new decision-makers.

Carefully consider the risk you run in an ownership change with your bank. Mergers and acquisitions (M&A) are now common in the banking industry. Bank failures, generally due to excess credit exposure in markets that could not sustain expected values will also cause regulators to seek out new owners. In each case, the commercial bankers that you have come to know and built relationships with could well be replaced. The credit policies that you have relied upon in obtaining capital for your business may change and become extra stringent, with more restrictive covenants or less flexibility in meeting the demands of the bank. There are many ways that a change in bank ownership and management can adversely affect your ability to supply capital for your business. So, what steps can you take to mitigate the risk of your bank changing the ground rules and potentially harming your access to credit?

An Action Plan for Bank Credit Risk

The primary objective in the mitigation of credit risk is to ensure that your organization has a sustainable access to capital. One of the foremost issues to consider in the design of your banking portfolio is diversification. While diversification is not the best solution for everyone, it may be beneficial to research the possibilities. Even though there are no guarantees that any bank will not be involved in a management change, the stronger capitalized banks will be less vulnerable.

Speak with bank associates and ask informally about how to take your banking to another level. Generally, your financial statements will need to support a history of reasonable profit and positive cash-flow. Although many businesses have unavoidably incurred losses over the past several years, evidence of a turnaround will be important. You will need to be able to present a practical business plan that demonstrates the company's future viability. While loan collateral is important in securing new credit, lending based strictly upon assets is not as common today. Now, many institutions require that prospective customers prove positive cash-flow and adequate collateral. Smaller companies may have a difficult time justifying more than one banking relationship. There may simply not be enough deposit or credit business to go around in which case you have all of your eggs in one basket. If this scenario describes your current banking relationship, it is recommended that your firm be proactive in determining that the bank relationship you choose is as stable as you can foresee.

The risk of capital loss is a critical part of an overarching risk-management program. In today's environment, a company's strong financial performance is one of the most important factors in reducing the risk of credit disruptions. Credit underwriting can be very arduous depending on the credit culture of your bank. Find out as much as possible about the underwriting process and talk with your banker in depth about the provided financial statements. Give your banker as much positive ammunition as possible regarding your company and the financial statements. Your banker should be a strong advocate for your company as the credit proposal winds its way through the credit committee. Having a banker who will go to bat for you is tremendously important, and developing a strong relationship with a commercial banker can pay very significant dividends.

Key Performance Indicators to Reduce the Risk of Capital Loss

As in any risk-management program, you will require the ability to measure risk and key performance indicators (KPI) that may be used to offset risk. What specifically does a bank credit analyst look for in examining the financial position of a company? This varies significantly by financial institution. However, many banks look for a strong debt to equity ratio and a positive debt-service ratio. Of course, many other KPI factors can be used, depending on the credit culture of the bank. A key internal metric that many banks use is Risk Adjusted Return on Capital (RAROC). Banks use different variations of RAROC to suit their own credit culture, but generally the bank will take your company's credit rating and adjust it for the amount of benefit your company brings to the table. Discuss this metric with your banker, but do not expect to get a detailed answer. Many banks will not disclose exactly how they calculate their RAROC. There are many variations on this central theme in the use of RAROC, so try to find out as much as you can about your bank's approach to determining a customer's profitability. A low credit rating diminishes RAROC and is improved by factors like non-interest bearing deposits and as many fees (401k custodial fees, for example) as you can centralize in one institution. Examine the fees that you are paying to various vendors versus the services your bank offers. If your bank can provide services that you are paying for elsewhere, you may consider centralizing those fees in which the RAROC metric will afford you the most benefit.

Proceed With Caution

Loss of capital can be disastrous to any business and this risk must be managed carefully. Handle inquiries about new banking relationships very carefully as these issues can be very delicate. While it may be desirable or necessary to consider a change in your banking relationship, remember not to burn bridges. Discuss potential changes with bankers informally in a "what if" context. In this way, no direct action is implied until you are sure you have all of the information necessary to take prudent steps to ensure your company's access to credit. Knowing how to bring more profit to your company's current (or future) bank will help further strengthen your firm's relationship.

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Ron Box, CPA.CITP, CFF, CISSP, is the chief financial officer and chief information officer for Joe Money Machinery, a Birmingham, AL.-based regional heavy construction distributor with operations in Georgia and Florida. Box also serves as chair for the 2010 AICPA Top Technology Task Force and is a member of the AICPA Certified Information Technology Professional (CITP) Credential Committee.