How secure are your "secured" lines of credit?

Two strategies to monitor line-of-credit collateral values--passive monitoring and informal asset-based monitoring--are frequently used in banks today. This article presents an emerging third alternative--active electronic monitoring. A fourth strategy that is not addressed--hope and pray--is one that has been employed in far too many situations.

Secured lines of credit are a staple of almost every bank's business product line. It makes sense to consider how secure these lines really are. Most often, secured [not equal to] secure, and banks must seek ways to ensure that their collateral exists in sufficient quantity if it is needed as a backstop against loss.

If the purpose of the line is truly to support short-term working capital needs, the bank wants to be confident that the cash conversion cycle of the business will retire the line, If a portion of the line is used for longer-term needs, the bank wants to be secure in the ability of the business to generate sufficient cash flow over time to term out such a facility.

Underwriting, whether based on financial statements and tax returns or a credit-scoring model, is designed to produce an acceptable level of confidence in repayment ability. Regardless of the underwriting method, however, most banks use collateral on small-business lines of credit as a security blanket. This practice can be the beginning of self-deception--calling their lines of credit "secured" generally gives banks a false sense of how secure they really are.

Banks may consciously choose not to monitor the collateral securing their lines of credit. For example, banks that use a credit-scoring model as their primary decision criterion often do not rely on collateral as part of their underwriting decision, and they have neither the desire nor the profit margin to monitor the credit. Those bankers have moved toward a monitoring-by-exception approach. If the collateral is there when it's needed, so much the better, but the bank is not counting on it. Monitoring of collateral values securing lines of credit is of much greater importance in banks that do not use commercial credit-scoring, in relationships where collateralized lines of credit exceed a certain size threshold, and in lines governed by either a formal or informal borrowing base.

Banks have historically turned to one of two strategies--passive monitoring or informal asset-based monitoring. A third, and perhaps better, strategy is active electronic monitoring. Each strategy has benefits and drawbacks, and none is a substitute for periodically going "beyond the numbers" to judge collateral quality more accurately.

The Passive-Monitoring Strategy

Many secured lines of credit are available for borrower draws without regard to any collateralization formula as long as no event of default has occurred and the line has not matured. While common in community banks, this disregard is found to some extent in larger banks as well. The obvious problem with this scenario is that collateral is unstable. As time passes, collateral may well reduce in quantity or quality.

The passive-monitoring strategy of dealing with this problem relies on the initiative and diligence of the individual lender to obtain interim financial information and review the value of collateral pledged against the line of credit. This approach is considered passive from a risk-control standpoint because it is not generally supported by any system of managed reporting and enforcement.

There are two primary pitfalls to this approach.

1. Individual lenders vary greatly in the amount of discipline they bring to their monitoring responsibility. Some are diligent in obtaining interim statements and in paying attention to the value of collateral pledged to the line. Unfortunately, many lenders use interim statements primarily to avoid financial statement documentation exceptions and do little to examine the statements or make other inquiries for information relative to both the value and quality of the collateral. Among banks in which passive line monitoring is the rule, there is typically no systematic process for evaluating collateral sufficiency and quality until the line is reevaluated for annual renewal, if then.

2. Even if lenders are diligent in obtaining interim statements, it generally takes a minimum of 30 to 60 days before such statements are received at the bank. Since the primary collateral for most lines of credit consists of accounts receivable and inventory, usually the most volatile of asset categories, the collateral could change dramatically or even disappear before the bank knows there is a problem.

Banks that rely on this passive strategy assume one of two things:

1. Their underwriting shows the borrower is strong enough to withstand a significant deterioration in its business to avoid reliance on collateral.

2. Their lenders are diligent and disciplined enough to discern significant shifts in the borrower's fortunes between annual credit renewals. Banks that have adopted an

Banks that have adopted an empirically driven credit-scoring model are making the first assumption with some justification. A bank that has proven over time that it can legitimately make one or both of these assumptions may well be justified in a passive-monitoring strategy. However, many losses on line-of-credit relationships have resulted from banks' misplaced reliance on "conservative" underwriting and loan officer diligence.

The Informal Asset-Based Strategy

Even if they have no formal assset-based lending (ABL) department, many banks approve credits for certain revolving line-of-credit borrowers by using borrowing-base formulas. During underwriting, the bank determines the categories of receivables and inventory against which it is willing to lend and the advance rates and other eligibility criteria to be applied to the collateral. The amount outstanding under the line of credit is limited to what can be supported by the borrowing base.

Practices vary from bank to bank and often from borrower to borrower within the same bank. Most situations, however, involve the periodic submission of paper-based accounts receivable data and inventory values and may or may not include lock-boxing of the proceeds from the accounts receivable. In employing an informal asset-based strategy, the bank is explicitly placing some degree of reliance on its collateral for repayment if the line cannot be repaid through the cash conversion cycle or through generation of cash over several operating cycles.

There are two principal advantages to the informal asset-based strategy:

1. The bank explicitly recognizes the need for active monitoring of its collateral position.

2. The bank links the allowable outstanding loan balance to collateral values as they change through time.

Institutions that have particular ABL expertise devote considerable time and resources to evaluating the quality of their collateral, setting appropriate advance rates and eligibility criteria, and managing their asset-based relationships in a very hands-on way, often in a specialized lending unit. While good ABL departments are typically very effective at controlling risk and are quite profitable as well, such operations tend to be the domain of regional and national banks and finance companies. Most of these institutions, seeking economies of scale, seldom focus on ABL transactions with less than $3 million in outstanding balances.

The pitfalls of the informal asset-based strategy relate not so much to problems with the concept as to its application. Leaving aside those relationships handled within specialized ABL departments, many banks are hampered by lack of consistency, lack of timeliness, and lack of discipline. As in passive monitoring, individual lenders may be tasked with monitoring the borrowing bases of their customers, and there is little consistency among lenders in their level of diligence. Even if the lenders are moderately diligent, the information required by banks from most of their informal asset-based borrowers may easily be 30 days old and stale by the time the bank receives it. Moreover, most banks have no organized system (outside their ABL department, if they have one) for tracking changes in collateral values and borrowing bases; in fact, many banks practice "desk drawer" tracking of revolving lines of credit. As a result, senior credit officers cannot feel comfortable that consistent monitoring discipline is act ually being maintained within the portfolio.

Active Electronic Monitoring

While both the passive-monitoring and informal asset-based strategies can be useful for certain borrowers, many banks are looking for a collateral-monitoring strategy applicable to a larger number of their secured credit lines while still both proactive and systematic. Last year, a small number of vendors began to develop straightforward systems for active electronic monitoring. These systems offer more monitoring discipline than passive monitoring, yet they are designed for use within traditional commercial loan departments rather than for specialized ABL departments. Depending on the vendor, some systems allow banks and borrowers to use Web-based application service provider (ASP) technology without the need for additional investment in hardware, while other systems involve software installation at the bank. More traditional software systems may be priced with a significant license fee plus annual maintenance and support fees, while the newer ASP systems are typically priced with a low entry fee plus fees b ased on the number of borrowers and outstanding balances of the lines being monitored.

Once a bank makes a decision to use such a system, it sets up borrowing-base parameters, collateral-eligibility criteria and advance rates, and requirements for borrower submission of collateral information. The borrower then submits its collateral information periodically in an electronic file extracted directly from its accounting system. This information is filtered through the parameters selected for that borrower in the monitoring system, and the system automatically detects and reports potential red flags, calculates the borrowing base, and reports borrowing availability or overadvances/overlines. Such information is reported for each borrower and (in an ASP system) is available for online browsing by bank personnel as well as by the borrower.

With the majority of banks currently employing either passive or "desk drawer" monitoring for the majority of their collateralized lines, active electronic monitoring offers several advantages:

* It quickly enables a bank to identify and quantify exposure to relationships exhibiting increased collateral risk and to institute better control over a significant part of its portfolio of working capital loans.

* It electronically provides information about collateral values, particularly the value of accounts receivable, that is much more timely and detailed than what most banks currently receive.

* It filters the information received from the borrower and scans for potential red flags that need attention.

* It instills both discipline and accountability into a monitoring process long dependent in most banks on the inconsistent efforts of individual lenders.

Online or other reporting offers lenders, their managers, and credit personnel much-improved control over changing credit circumstances.

The primary implementation challenge for the active-electronic-monitoring strategy lies in whether senior lenders and senior credit officers will mandate such monitoring to their lenders as part of the bank's approval criteria or policy for collateralized working capital lines. In the absence of such a mandate, lenders will tend not to impose on borrowers even the simple information uploads needed by the system to perform its intended monitoring and reporting functions--in such cases, the bank unintentionally slips back into a passive mode. Banks that make active electronic monitoring an integral part of their risk control efforts, however, typically find much more borrower cooperation than lenders anticipate.

To gain such borrower cooperation, active electronic monitoring is typically best implemented in conjunction with one of the following events:

* The borrower requests an increase in its line.

* The line is reviewed for annual renewal.

* The borrower's financial condition deteriorates significantly.

* A borrower requests a new line of credit.

Such events provide a more natural time for both lenders and borrowers to discuss a change in monitoring procedure.

Making Secured = Secure

Monitoring collateral rather than just taking collateral, when combined with traditional financial analysis, is what makes a secured line of credit actually secure. Active electronic monitoring offers a way for banks to be more proactive in controlling their risk while gaining much of the structure that has traditionally been the domain of specialized ABL departments. Obviously, the larger a bank's secured line-of-credit portfolio, the more benefit the bank can realize. But with the technology now available on a "pay-as-you-use-it" basis, even relatively small community banks that are active line-of-credit lenders are beginning to adopt this strategy Active electronic monitoring will continue evolving to meet the needs of lenders, borrowers, and regulators for proactive and systematic tracking and control of line-of-credit portfolios.

Secured Line-of-Credit Monitoring Strategies

                   Passive            Informal Asset-
                   Monitoring         Based Monitoring

Consistency of     Typically          Variable; heavily
monitoring         low, but           relies on individual
discipline         varies greatly;    lender initiative,
                   heavily relies     but may have analyst
                   on individual      backup for tracking
                   lender initiative

Way in which       Financial          A/R aging, A/P aging,
collateral values  statements         and inventory
are gathered                          certificate
from borrower

Frequency of       At least annually  Typically monthly
information

Means of receiv-   Hard copy          Typically hard copy
ing information

Timeliness of      Typically 90-120   Typically 30-45 days
information        days after year-   after month-end
                   end; 30-60
                   days if interim

Metod of           Manual analysis    Manual or spread-
comparing                             sheet calculation
collateral                            of borrowing base
values
to line
outstanding

Method for         Manual analysis    Manual analysis
detecting red
flags


Reports            Manual, if any     Manual or spread-
available to                          sheet reporting
bank manage ment                      is typical



Reports available  None typically     None typically
to borrower




                   Active Electronic
                   Monitoring

Consistency of     High; lender and
monitoring         bank management
discipline         may receive e-mail
                   prompting of actions
                   needed


Way in which       Electronic files of
collateral values  A/R and inventory
are gathered       values, and A/P to
from borrower      check for contras

Frequency of       At least monthly, but
information        typically weekly

Means of receiv-   Electronic file
ing information

Timeliness of      Information current
information        as of posting date
                   before file is
                   uploaded

Method of           Automated calcula-
comparing          tion of borrowing
collateral         base
values
to line
outstanding

Method for         Automated scanning
detecting red      for red flags per
flags              bank-defined
                   parameters

Reports            Automated reports
available to       and notification of
bank manage ment   red flags available at
                   loan officer, branch,
                   and bank levels

Reports available  Borrowing base and
to borrower        ineligible amounts
                   may be available via
                   the Web as read-only
                   information

[c]2003 by Private Business, Inc.All Rights Reserved

Paul Sims may be contacted by e-mail at psims@guided-solutions.com

C. Paul Sims is president of Guided Solutions, a bank consulting firm in suburban Nashville, Tennessee. He was formerly the director of bank services for Private Business, Inc., which licenses the LineMauager[R] line monitoring system and the BusinessManager[R] receivables purchase program to banks nationwide. He has presented at the RMA Annual conference and is a former officer of RMA's Mid-South Chapter This is his third article published in The RMA Journal.

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