How Lenders Evaluate Credit Risk

The greater the perceived risk of a loan, the higher the required return in the form of interest. However, different lenders have different parameters regarding their pricing and tolerance for risk.

In this lesson, you’ll learn the basics of how lenders evaluate credit risk. By understanding the needs and objectives of different lenders, you’ll be better prepared to determine which source of financing is the right fit for your business over time. Pursuing a misfit can waste your time and money.

Inexpensive Capital Means Low Tolerance for Risk

The relatively low cost of bank debt makes it a very popular form of financing. The hitch is that lenders in general, and banks in particular, can’t tolerate much uncertainty. Because lenders’ returns are typically limited to interest income, uncertainty translates into a risk of loss, and banks can ill afford to lose money on loans:

  • The profit margin on a bank loan is razor thin. A 3% to 6% margin is pretty typical.
  • Banks are highly leveraged. That is, they borrow money in the form of deposits in order to make loans to others. Leverage magnifies a bank’s stockholders’ returns when all goes well, but leverage also magnifies the effect of losses.
  • Banks are highly regulated. In exchange for the benefit of FDIC deposit insurance – which dramatically reduces banks’ cost of funds and allows them to charge relatively low rates of interest – banks must abide by restrictions imposed by Federal and state regulators.

Banks’ loss aversion combined with restrictions on their ability to price risk means that the availability of bank debt is constrained. According to the Federal Reserve Bank, only about 1/3 of businesses having annual revenues of less than $250,000 are able to receive “all or most” of their desired credit:

Smallest Businesses Can't Access Desired Credit

Smallest Businesses Can’t Access Desired Credit

Some of that shortfall is being met through the emergence of non-bank alternative lenders who are using innovative credit evaluation (i.e. underwriting) techniques and who have fewer loan pricing restrictions (i.e. many charge 30% APR or more for their money).

Alex McLeod and I had a conversation about the business model factors that drive bankers’ behaviors that elaborates upon some of the themes introduced in this lesson:

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How Lenders’ Evaluate Credit Risk

A common framework for evaluating the risk of a loan is referred to as the 5 C’s of Credit:

The 5 C's of Credit

The 5 C’s of Credit

These factors are, to a degree, substitutes for one another regarding their contribution to perceived credit quality. Strong collateral in the form of accounts receivable, for instance, might offset uncertainty regarding the borrower’s ongoing debt repayment capacity (e.g. in the case of asset-based lenders).

Contributors to Perceived Credit Quality

Contributors to Perceived Credit Quality

Collateral and capital are easily quantified and, therefore, readily available for formulaic credit evaluation. The evaluation of capacity through the modeling of past and anticipated future cash flows requires a bit more effort. Conditions and character are relatively subjective and less easily quantified.

Relative Quantifiability of 5 C's of Credit

Relative Quantifiability of 5 C’s of Credit

Underwriting Models

Different lenders utilize different underwriting models. That is, they place differing emphasis on the various contributors to credit quality when deciding whether, and under what terms, to extend credit to a prospective borrower.

Community banks are well-positioned to take all five credit factors into account. Local knowledge allows community bankers to incorporate positive assessments of character and local conditions into their credit evaluations. So even when there are perceived deficiencies in collateral and capacity, for instance, a community bank may be able to prudently judge a borrower to be creditworthy.

Small Banks are a Vanishing Breed

Small Banks are a Vanishing Breed

However, with the continued consolidation in the banking industry, there are fewer community banks. So, new entrants such as Kiva and Able Lending have assumed the mantle of character-based lenders. Rather than having local bankers on staff who can know borrowers personally, the new generation of character-based lenders rerequires validation in the form of a threshold amount of “friends and family” loan participation before risking their own capital. In a sense, lenders such as Able Lending outsource the character-evaluation process in a manner that allows them to extend credit across the country without the cost of a national network of local bankers.

As the term suggests, asset-based lenders tend to rely more heavily on collateral in their underwriting decisions. Factoring, for instance, is technically the sale of eligible accounts receivable to a third party at a discount to face value. In effect, the lender or “factor” might advance $0.80 today in anticipation of receiving $1.00 within 60 to 90 days. Asset-based lending is more broadly available than bank debt…but at a cost.

Many marketplace lenders (e.g. Kabbage) use proprietary algorithms to make informed inferences regarding the 5 C’s of credit. That is, big data and technology substitute for the judgement of an experienced lending officer.

Analysis of the daily stream of credit card sales of an e-commerce retailer, for instance, measures capacity. When combined with a contract that anticipates daily collections to be applied toward the loan or advance, the “merchant cash advance” model operates in a manner very similar to accounts receivable financing.

Pricing Models

All lenders ration and price risk. That is, they establish standards that set a limit on how much risk they will underwrite, and they charge a rate of interest within a range.

The price charged on loans may be subject to state usury laws. Banks tend to have less flexibility regarding interest rates than do alternative lenders. As a consequence, banks ration credit more restrictively than do alternative lenders. However, bank debt tends to be a lot less expensive. Because more relationship-based alternative lenders such as Able Lending can more effectively take character into account when underwriting, they can make credit available to small businesses who can’t yet access bank debt at a rate of interest that is lower than the rates charged by asset-based alternative lenders.

Asset-based and Relationship-based Alternative Lenders

Asset-based and Relationship-based Alternative Lenders

Summary of Key Ideas

  • There are several types of lenders. Each has a different tolerance for risk and can offer varying degrees of pricing flexibility.
  • Pursuing a lender that is a mismatch with the characteristics and goals of your business can waste your time.
  • Banks can typically offer the lowest rates of interest, but they also have the lowest tolerance for risk. That’s one of the reasons that a consolidating banking industry continues to move away from small borrowers.
  • Traditional and marketplace lenders who focus on asset-based loans make credit available to smaller, less established businesses, but the price can be very high.
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Lesson tags: financing