It is the quality of lending over the quantity of lending — Lewis Thompson Preston.
Too often, during boom periods in the business cycle, the line between quality and quantity, the two concepts identified by Preston, becomes decidedly blurred.
For most banks and financial institutions, the primary means by which to generate income is lending money. Loans are the most profitable way to deploy depositor funds, balance sheet liabilities that typically require interest payments to attract.
When making loans, the type, quantity and quality of credit extended depends upon the business strategy of the specific lending institution.
- Some lenders choose a very conservative business model, making loans to only the strongest and most qualified applicants and thus taking on relatively little risk. As a result, their overall interest income is lower due to charging preferential interest rates and carrying fewer loans on the books, but losses on those loans are also lower.
- At the other end of the spectrum are high risk/high reward lenders, such as those that comprised the sub-prime industry that artificially inflated — and ultimately derailed — the housing market. For those institutions, yields are far higher due to the additional risk incurred, but so are the potential losses taken.
In an attempt to balance risk and return, most lenders operate near the middle of the two extremes. Although historic circumstances such as the crash of the housing market can (and in many cases did) upset that balance, it still remains the most effective long-term strategy to maximize return while diversifying risk. Not only is portfolio risk management a major consideration, but underwriting to ensure each individual loan is of an acceptable quality is an essential part of the lending process.
The Five C’s of Credit
In order to properly underwrite a loan request, lenders need to consider multiple factors. Although there are variants, those factors are generally grouped within what has been colloquially termed “the five C’s of credit,” as follows: Capacity, Capital, Collateral, Conditions, and Character.
Below is a closer look at each:
Capacity: How Much Loan Can You Afford?
First and foremost, the lender must attempt to measure and determine the borrower’s ability to make their loan payments. Historical and projected income are typically quantified in the process, both on a project-specific basis (such as purchasing a house or starting a business) as well as by identifying other sources of income the borrower may have. The financial institution will attempt to mitigate the variable risk of a borrower’s income by analyzing secondary sources of income that can be used to help make payments as necessary. Global cash flow is the most popular way to capture all source of income in the underwriting of the loan.
Although all of the factors analyzed are important, capacity belongs at the top of the list. If the borrower doesn’t have the ability to make payments, it is unlikely they will be able to remain in good standing for long.