We have all watched with much concern the unexpected and rapid unraveling of Silicon Valley Bank and Signature Bank over the past week. Many pundits are asking whether this is the start of another wave of bank failures and other financial system pressures, or whether the issues that caused the unraveling are germane to just these two organizations.
As a former bank executive, I watched with grave concern as we have learned of the imprudent balance sheet management, and interest rate risks taken by both institutions. In both cases, management, and the board’s objective to chase the higher yields provided by holding longer dated investment securities drove higher near-term earnings but blinded them to the outsized risks they were taking.
I am confident that there will be much finger pointing as to who was accountable for such actions including bank leadership, federal and state bank regulators, the Federal Reserve, and others. However, in the final analysis, bank management and the board of directors must shoulder the responsibility for their actions. After all, regulators set the parameters within which banks operate, but they did not make the day-to-day business and risk decisions that ultimately put these, and likely other banks at risk.
While this 2023 mini banking crisis differs from the 2008 financial crisis in that it does not appear that it was driven by bad credit decisions, or imprudent lending practices generally, this is a great time to review the 5 Cs of credit. In my new book Taking Stock (to be released on March 23rd), I discuss the importance of adhering to the 5 Cs of credit. These 5 Cs are the time-tested standards by which banks and other financial institutions determine the creditworthiness of a borrower.
The 5 Cs of credit are capital, collateral, capacity, conditions, and character. Here is a brief overview.
Capital: Capital represents the total amount of assets invested. Having a strong capital position enables borrowers to withstand sudden shocks either to their own condition or the external environment. Borrowers (companies or individuals) with low capital levels typically represent a higher credit risk to the lender.
Collateral: Collateral is the asset that a company or an individual pledges to secure the loan. Collateral can take many forms, including cash, securities, the title to a building, certain equipment, a life insurance policy, an automobile, and other hard assets that can be liquidated in the event the borrower defaults on the loan. Lenders don’t want to liquidate the collateral to get repaid because there is no certainty as to the value of the collateral at the time it needs to be sold. The liquidation of collateral can be very messy and is always the last resort.
Capacity: Capacity is a measurement of the ability to repay the loan from regular, predictable cash flows and other sources of income. Lenders want to see that there is enough ongoing capacity to ensure repayment. Certain financial ratios are used to determine and monitor borrower capacity.
Conditions: Conditions are the specifics of any transaction, including the principal amount, interest rates, and any guarantors that might be required to strengthen the loan. Conditions also consider the health of the economy, unemployment, and other external conditions.
Character: Character is a comprehensive assessment of an individual or company’s track record of paying back prior loans, even if events turn negative. Character can be assessed in quantitative and qualitative terms. A lender can look at credit reports, repayment history, and other quantitative elements to determine the likelihood that an individual or business will repay a debt. The qualitative assessment of an individual’s willingness to repay a loan even when the chips are down is extremely important. This is the real character part of the assessment. In my view, this is the most important of the 5 Cs. Many loans that meet the other criteria will be turned down based on concerns about character alone, as they should be. However, some loans that fall short on the quantitative analysis of the 5C’s may be approved based upon the borrower’s high character, reputation, and prior repayment history.
I hope that the banking industry has been adhering to the 5 Cs over the past few years. If not, we could be sailing into even rougher waters over the next few months.