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Supervision News Flash

November 2019

Detect Borrower Distress Early To Be Sure You Have a Chair if the Music Stops

Loan Agreement

Maintaining credit discipline 100 percent of the time is challenging, especially when times are good. During the last recession, examiners found that banks that effectively underwrote and monitored their more complex borrowers were able to minimize losses, compared with other institutions lending to the same kinds of borrowers. They did this through earlier identification of potential borrower distress.

One positive outcome from the last recession was that many banks learned the necessity of early problem identification, and they instituted practices that support a sound and disciplined credit culture. This culture now permeates their underwriting and portfolio monitoring practices, regardless of the economic cycle. While there are many elements that contribute to a sound credit culture, we have observed one practice that, when consistently applied, will aid an institution with earlier identification of borrower distress. This practice is the use of a Global Debt Service Coverage Ratio (GDSCR).

The many benefits of the GDSCR calculation include:

  • A comprehensive view of all debt service requirements and cash inflows and outflows
  • A clearer picture of the contingent debt that competes with your loan’s repayment scenario
  • A window into the local project’s and guarantor’s true liquidity profile
  • The identification of potential lending or other business development opportunities
  • If regularly calculated (e.g., at annual renewals), a way to monitor the condition of a borrower or an entire portfolio and identify emerging risks
  • Early warning signs of potential borrower distress

One reason the GDSCR is so helpful is that lenders obtain and analyze a lot more information about the borrower. Presumably, this translates into earlier risk identification. In addition to the advantages outlined above, GDSCR has other benefits. For example, risks posed by other projects and commitments can be identified and mitigated through effective use of loan terms and conditions such as covenants. In addition, lenders are in a better position to monitor the borrower more holistically, and can proactively protect the bank if weaknesses emerge during the term of the loan (e.g., perfect additional collateral before another lender does). Naturally, lenders must ensure that all relevant documentation (e.g., all business and personal tax returns, K-1s, etc.) are available for review and included in the calculation. This means lenders must be diligent in collecting all the documentation during origination and at regular intervals.

Regular use of the GDSCR calculation may help you identify problems earlier; however, use of the GDSCR is not a regulatory requirement. There are times when examiners may reference the use of the GDSCR as part of corrective action resulting from an examination finding. These types of findings generally arise when examiners note issues with how an institution is underwriting and/or monitoring their more complex or riskier borrowers. In summary, using the GDSCR is a good way to get the information you need to ensure you have a chair if the music stops.

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