The federal and state bank regulators, under the auspices of the Federal Financial Institutions Examination Council, recently issued the “Interagency Statement on Meeting the Credit Needs of Credit Worthy Small Business Borrowers” (“Statement”). The Statement indicates an intention to build upon existing guidance that sets forth regulatory policies on supervising small business lending. However, it appears motivated, at least in part, by banking industry complaints about examiner overzealousness in reviewing small business loans.
The Statement refers to lending data in noting that small businesses are experiencing more difficulty borrowing to support their operations. That decline in small business lending is attributed to “weakness in the broader economy, decreasing loan demand, and higher levels of credit risk and delinquency.” The Statement notes that institutions have responded to those factors by tightening underwriting, reviewing lending practices and capacity and reducing lending to strengthen capital levels and balance sheets.
While the Statement deems many of the responses as prudent, it notes that regulatory experience indicates that institutions sometimes overreact to a serious economic downturn by excessively tightening lending. Noting the adverse economic effects of unnecessary reductions in credit availability, the Statement indicates that regulators want to ensure their policies “do not inadvertently curtail the availability of credit to sound business borrowers.” Toward that end, the Statement says that “[f]inancial institutions that engage in prudent small business lending after performing a comprehensive review of a borrower’s financial condition will not be subject to criticism for loans made on that basis.”
The Statement goes on to set forth policies and procedures that the regulators regard as necessary for small business lending. Those include an in-depth understanding of the borrower’s business plan and the planned use for, and sources of repayment of, the loan funds. Also deemed imperative is a thorough review of the local market in which the borrower competes. On that point, the Statement states that institutions should not rely on national trends in the borrower’s business where local trends may be more favorable. The Statement also reflects the regulators’ expectations that credit not be routinely declined because of a borrower’s geographic location or industry. Instead, it urges that judgments be made on the creditworthiness of individual borrowers, consistent with sound management of credit concentrations.
Analysis of the borrower’s prospective cash flows is also deemed crucial to effective credit decisions. The Statement says that such analyses should cover current and expected cash flows based on reasonable, not overly pessimistic or optimistic, assumptions. If a borrower uses personal financial strength to support the credit application, that should be evaluated along with other underwriting criteria, such as the strength of the business’s management. Secondary sources of repayment, like guarantees or collateral, are also considered important factors in the underwriting judgment, as is the prospective ability of the borrower to raise additional capital. The Statement provides that institutions should not place undue reliance on cyclical factors, such as appreciating or depreciating collateral values, and stresses the importance of structuring small business loans to meet the particular cash flow needs of the borrower’s operations.
The Statement also specifies some general lending principles, stating that institutions should have “robust” risk management practices to identify, measure, monitor and control credit risk. Further, institutions are urged to promote a credit culture in which lenders develop and maintain prudent lending relationships and knowledge of borrowers. Underwriting staff should be encouraged to use sound judgment. Institutions should not use general modeling to identify and manage concentration risk to the exclusion of evaluating repayment capacity individually.
The Statement provides that “[e]xaminers will not discourage prudent small business lending by financial institutions, nor will they criticize institutions for working in a prudent and constructive manner with small business borrowers.” Examiners will expect institutions to use sound underwriting and risk management practices, maintain adequate loan loss reserves and capital and take appropriate charge-offs as warranted. The Statement specifically directs examiners to take a balanced approach in assessing the adequacy of risk management practices for small business lending. According to the Statement, loans will generally not be classified solely due to a reduction in the collateral value below the loan balance if the borrower has the willingness and ability to repay the loan according to reasonable terms. Additionally, it says that examiners will not classify loans just based on the borrower’s association with a particular industry or geographic location under financial stress.
Although the Statement does not directly say so, its issuance was at least partly a response to complaints by banks and thrifts that examiners were being overzealous in their criticisms of small business loans. Industry trade groups have testified before congressional committees that examiners were being unduly restrictive in their analyses of small business loans and too hasty to downgrade such loans. In turn, banks and thrifts became less likely to extend such credit, even to creditworthy small businesses. The Statement appears to serve the dual purpose of facilitating the regulators’ instructions to their examiners to practice sound judgment in evaluating small business loans while attempting to demonstrate to the banking industry that small business lending will not be subjected to unreasonable supervisory policies. Whether the Statement is implemented in practice by the examiners remains to be seen. At a minimum, the Statement adds a tool that bank and thrift management can use when discussing particular small business loans with examiners and/or appealing, under agency procedures, examiners’ classifications of such loans.