Banks are in the business of taking and managing risks. Get that wrong and you go out of business, and there are many recent examples.
I have sometimes worked with advisors who view loans as just another product to sell. This type of advisor also tends to view anyone in the credit underwriting and approval process as being in the “business prevention department”. In these situations I try to explain how lending literally involves transferring some of the firm’s capital to a client, on which we expect a return of principal and a return on principal over time.
No matter how much profit the client makes as a result of a loan, a lender’s best case is getting a full return of principal, plus the contractual interest, and not a penny more.
$1 million loan x 2.00% spread = $20,000 of pre-tax, pre-provision revenue
The lender’s worst case is a complete loss of principal and expected interest, plus collection and litigation costs.
The firm that charges off that $1 million loan needs $50 million of new loans to get back to even.
And that excludes income taxes, labor or overhead costs needed to originate the loan, any loan loss reserves set aside, the cost of funds raised to lend out or any time-value of that money (i.e., liquidity issuance premium).
With that kind of mismatched upside/downside risk, it is necessary to view lending like the private fixed income investment that it truly is.
How advisors should think like fixed income investors:
- They must seek an attractive risk-adjusted after-tax return on capital
- They should expect low loss rates and low volatility of returns
- They have to achieve these goals through disciplined management of controlled risks
- Borrowers typically do not have public debt ratings, so individual underwriting must be performed
- Borrowers typically do not have established market values, so risk-adjusted pricing must developed
- Bankers must mitigate these risks through disciplined underwriting, appropriate credit structure and active portfolio monitoring and management.
Advisors that balance the needs of their clients with the long-term health of their firm win in the long run.