Credentials for Credit

What guidelines do banks use for extending credit? StaffApril 13, 2001

Q: What are some specific key parameters banks are using as credit guidelines over time, and how do those guidelines change? For example, if a bank is tightening credit, what does that mean? I have done my own polling of banks from time to time, but it would be nice if there was a more scientific method that financial executives can easily use as benchmarks.

Tom Mahoney
Savage, Minn.

This week’s response comes from credit-risk research firm KMV LLC. Below, chairman Mac McQuown and CFO Larry Reed give us the skinny on how banks extend credit.

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A: There is no science around “tightening” credit, and there cannot be.

Tightening credit is a variation on “no credit at any price.” It might mean raising spreads, for example in response to increasing riskiness of obligors, which is fully rational and should always apply. Spread (to the default-free) should reflect risk, and usually does.

When equity prices fall, the risk of all corporate credit increases. This is because the value of collateral has fallen. The remedy would be for the corporate borrower to put up more collateral or pay down part of the loan, or for the lender to increase its lending spread. Both are reasonable behaviors.

Some bankers refuse to extend credit at any spread to certain obligors or against certain collateral, at least some of the time. This makes little sense; it’s the equivalent of putting an infinite spread on a credit and cannot possibly explain the system as a whole. But even if a single bank does not extend credit to a particular obligor/collateral, say, because they already have too many similar exposures, it doesn’t follow that another bank will act the same way. Bankers do not all act alike. Banks have vastly different portfolios of risk, and therefore propensities to lend at any given moment.

Mac McQuown, chairman, KMV LLC

The Federal Reserve Board does a quarterly survey of senior loan officers to assess whether banks are loosening or tightening loan standards. In the March 2001 survey, they find banks tightening and cite as evidence: raising loan fees, increasing loan spreads, tightening loan covenants, and increasing collateral requirements. Though the Fed does not include the question in its survey, I wouldn’t be surprised to find that they also became tighter on key financial ratios.

Larry Reed, CFO, KMV

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