How Secure Are Your "Secured" Lines of Credit? (Emerging Technology)

By Sims, C. Paul, Jr. | The RMA Journal, April 2003 | Go to article overview

How Secure Are Your "Secured" Lines of Credit? (Emerging Technology)


Sims, C. Paul, Jr., The RMA Journal


Two strategies to monitor line-of-credit collateral values--passive monitoring and informal asset-based monitoring--are frequently used in banks today. This article presents an emerging third alternative--active electronic monitoring. A fourth strategy that is not addressed--hope and pray--is one that has been employed in far too many situations.

Secured lines of credit are a staple of almost every bank's business product line. It makes sense to consider how secure these lines really are. Most often, secured [not equal to] secure, and banks must seek ways to ensure that their collateral exists in sufficient quantity if it is needed as a backstop against loss.

If the purpose of the line is truly to support short-term working capital needs, the bank wants to be confident that the cash conversion cycle of the business will retire the line, If a portion of the line is used for longer-term needs, the bank wants to be secure in the ability of the business to generate sufficient cash flow over time to term out such a facility.

Underwriting, whether based on financial statements and tax returns or a credit-scoring model, is designed to produce an acceptable level of confidence in repayment ability. Regardless of the underwriting method, however, most banks use collateral on small-business lines of credit as a security blanket. This practice can be the beginning of self-deception--calling their lines of credit "secured" generally gives banks a false sense of how secure they really are.

Banks may consciously choose not to monitor the collateral securing their lines of credit. For example, banks that use a credit-scoring model as their primary decision criterion often do not rely on collateral as part of their underwriting decision, and they have neither the desire nor the profit margin to monitor the credit. Those bankers have moved toward a monitoring-by-exception approach. If the collateral is there when it's needed, so much the better, but the bank is not counting on it. Monitoring of collateral values securing lines of credit is of much greater importance in banks that do not use commercial credit-scoring, in relationships where collateralized lines of credit exceed a certain size threshold, and in lines governed by either a formal or informal borrowing base.

Banks have historically turned to one of two strategies--passive monitoring or informal asset-based monitoring. A third, and perhaps better, strategy is active electronic monitoring. Each strategy has benefits and drawbacks, and none is a substitute for periodically going "beyond the numbers" to judge collateral quality more accurately.

The Passive-Monitoring Strategy

Many secured lines of credit are available for borrower draws without regard to any collateralization formula as long as no event of default has occurred and the line has not matured. While common in community banks, this disregard is found to some extent in larger banks as well. The obvious problem with this scenario is that collateral is unstable. As time passes, collateral may well reduce in quantity or quality.

The passive-monitoring strategy of dealing with this problem relies on the initiative and diligence of the individual lender to obtain interim financial information and review the value of collateral pledged against the line of credit. This approach is considered passive from a risk-control standpoint because it is not generally supported by any system of managed reporting and enforcement.

There are two primary pitfalls to this approach.

1. Individual lenders vary greatly in the amount of discipline they bring to their monitoring responsibility. Some are diligent in obtaining interim statements and in paying attention to the value of collateral pledged to the line. Unfortunately, many lenders use interim statements primarily to avoid financial statement documentation exceptions and do little to examine the statements or make other inquiries for information relative to both the value and quality of the collateral. …

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