Due Diligence - A Critical Banking Tool
Wayne H. Frederick, President
The WFA Group
Houston, Texas
www.wfagroup.com
It has been said “It is a wise banker who knows his own customer.” This was especially true in the yesterdays of banking. However, because of the way the majority of commercial loans are generated in the marketplace today, you may not really know your customer. Therefore, you have to rely on your usual credit and loan due diligence requirements.
The need for due diligence is well understood by the majority of commercial lenders in the banking world, but in practice it is often overlooked for a variety of reasons: balance sheet comfort, competition, confidence in the company’s good track record, pressure to book the loan, senior management not requiring it, and “I’m too busy to be bothered.” (yes, we have heard that before).
In view of the current monumental losses sustained by the mortgage loan industry as a result of large financial institutions dealing in sophisticated lending diversions which few people understand, it is an appropriate time to consider some of the basics in due diligence.
Due diligence dictates that loans be both safe and sound. A sound transaction is supported by cash flow that is reliable and sufficient to service the needs of the borrower. A safe transaction provides a second source of repayment, typically collateral for the loan. Yet, not all collateral is created equal nor will it necessarily be where you expect it to be, or have the value you hope it has, if you ever need to call upon it; hence, the case of the so-called Collateralized Debt Obligations.
Due diligence is an essential tool in the banker’s arsenal to prevent or minimize losses from fraud and to help prevent mistakes resulting from bad judgment which can happen when the lender lacks experience. Some bankers have mentioned that they have an internal due diligence program in place which they believe is enough to remove the risk of making a commercial decision; however, experience dictates this is not the case. Experience is a great teacher and even better if we can learn from the experiences and mistakes of others. Many bankers and corporate lenders, hungry for new business or complacent with existing business, look the other way even though there are doubts about the veracity of the borrower’s balance sheet.
Those people who have spent their business careers in due diligence know it is an advisory process that supplies information to assist in decision making, but it is not fool-proof. In essence, it is a form of “insurance” fundamental to the survival of any risk-based lending function, and it is only effective if policy has been established and followed properly. Practicing due diligence is required to create awareness among all banking staff, more so among the lenders. It helps bankers identify the warning signs or “red-flags” that there may be a problem or potential problem with a new business application or an existing relationship. This is why there is a need for internal checks and balances which should be followed but which may be ignored in the quest to book the loan, i.e., sub-prime mortgage loans.
There is also a need for external pre-loan and regular compliance examinations of collateral to ensure that there is not a problem waiting to manifest itself, i.e., asset-based lending for providing working capital. It is in this area that historically banks have not been strong in monitoring collateral. They generally require a monthly borrowing base report or collateral certificate that states the borrower’s collateral position at month’s-end vs. the existing loan against the total line of credit. This may or may not be reviewed by the bank’s analyst and then placed in file along with the other monthly reports. This report may satisfy the requirements in the loan agreement, but it can be a perfunctory procedure since the accuracy of the report may be questionable. The requirements to properly complete a borrowing base report are often not fully explained at loan closing. The borrower then turns over this requirement to someone in the accounting department to complete at month-end in order to comply. It becomes a fill-in-the-blanks by number that may reconcile with the balance sheet. This procedure is better than no reporting procedure at all but basically is a “half” measure of monitoring collateral.
Lenders periodically ask, “When should we require field audits or collateral examinations?” The answer is that due diligence requires them whenever you make a secured loan involving accounts receivable and inventory (if part of the borrowing base) where the worth of the collateral is material to the worth of the company you are financing and to the security of your loan. Valuable lessons have been learned or should have been learned about the benefit of effective due diligence. It is THE REDUCTION OF RISK AND LIABILITY.
If there is a lack of secured lending experience in the bank then you should require some external training so lenders are aware of the problems in the areas of fraud and collateral compliance. Unfortunately when this awareness isn’t present, lenders become reactive to the immediate problem instead of proactive when the loan is being considered. A lot of time and money is lost on wasted effort after the problem occurs rather than preventing it in the first place.
Under no circumstances should a due diligence report be edited for content by excluding certain negative material or comments in order to get a loan approved. On the other hand, due diligence is not just a search for the negative or what is termed “suspicious.” It should also reveal positive factors that an astute banker can use to nurture business relationships. The due diligence process benefits and strengthens a commercial relationship and therefore encourages further business. Most importantly, effective due diligence enhances a bank’s reputation with the regulatory authorities, its shareholders, and above all, its customers. It is an essential component in good business practice. I haven’t heard of any banks being criticized for ethical behavior.
It has been said that “timely disbursements to prepare for danger frequently prevent much greater disbursements to repel them.” In other words, an ounce of prevention is still better than a pound of cure.
