There was a story about a shy skinny kid who loved baseball who went to school to tell the class an amazing story of a pitcher who had an Earned Run Average (ERA) of 135. His teacher/coach told him he was a fool and ridiculed him in front of class, explaining that everyone knows a pitcher's ERA can never exceed 27, the number of outs in a baseball game. In reality, this pitcher had allowed 5 runs and gotten only one batter out. Getting one batter out is the equivalent of pitching 1/3 of an inning or 1/27th of a game. If 5 runs were scored, the equation is 5/(1/27) = an ERA of 135. The kid took a newspaper to school showing the ERA of 135, the teacher/coach/bully told him to sit down and be quiet, but it was clear that the math had beaten the bully.
As bankers, we love numbers and we know they can be used to prove many different things. One of the most important aspects of our advanced understanding of numbers is using the ones that help us understand risk and opportunity the most. Most banks using a best practice calculation for the probability of default (PD) and expected loss of a loan use metrics for both collateral and borrower cash flow.
Most lenders we know love collateral and they especially love real estate collateral. We suggest however that an analysis of borrower cash flow is oftentimes more important than the ability to oversee a property. That said, it is certainly comforting to drive by the collateral backing a loan on a specific property on the way to work. This is especially true when this collateral backs a big loan that makes up an important part of the bank's producing portfolio. It can also give an idea of the health of the borrower and can perhaps indicate when things are going wrong.
In reality, collateral value is often more an effect than a cause. If a property isn't being maintained, it may be because the borrower is strapped because business isn't that good or it could be due to unrelated external issues. What about the other direction? If a property appreciates significantly in value, is the lender in any position to benefit from that knowledge? Does it mean the bank should automatically offer this borrower additional credit?
This is why we feel knowledge of the cash flow of the business is far more indicative of whether the borrower will be able to meet the requirements of the loan than the value of the collateral (although both are important).
Banks that are good cash flow lenders have many avenues open to them. For example, consider C&I lending. Many banks don't actively prospect for these loans because there often is little tangible collateral (and you really have to keep your website cutting edge to handle customer needs).
A borrower's cash flow in the end tells the bank more about its risk and opportunity with a customer than other indicators. Cash flow lenders need to have strong oversight and do analysis on a regular basis to ascertain that a borrower will be able to meet the obligations of the loan. The good news is that when doing this work consistently, you may also discover an opportunity if a borrower's cash flow is getting stronger and their business is thriving. An appreciating property value may indicate robust growth in the customer's financial strength or it may be due entirely to external factors. Having advanced analysis allows lenders to know the difference.
Our advice it to not only monitor the collateral, but also to pay particular attention to the cash flow of borrowers. It will help your bank manage risk and even more important, find opportunity. In the face of likely short term interest rate increases, it makes good sense to keep in close touch with the financial health of your borrowers. The intelligent use of the math gives your bank a leg up on the competition, whether it's the big bullies like B of A and Wells or other competing institutions.