Clean up your Lines of Credit!
The banking industry’s asset quality metrics perhaps have never been better. The economy is growing over 3% for the past few quarters and underwriting standards have improved (although becoming stretched as competition remains fierce, but that’s a topic for another day).
So why am I now suggesting banks need to begin conducting some commercial credit line housekeeping? First, it is sound banking practice to make sure revolving lines of credit are being used appropriately by borrowers (i.e. line balance is related to increases in temporary working capital, not permanent working capital). Second, line commitments impact a bank’s risk-based capital requirements and the cost to maintain under-utilized (or unutilized) lines of credit should be not ignored. Third, there appears to be some headwinds beginning to emerge such as the Fed’s stated intention to continue tightening through 2019, the current trade skirmish with China and the mere fact that many economists believe we are in the late innings of this historically long economic expansion.
Businesses that have a legitimate need for revolving lines of credit utilize usually use them responsibly and as originally intended. However, many banks have lines of credit that experience very limited or no utilization when the borrower’s actual need is less than anticipated. During my 20+year lending career, I observed that this happens for the following reasons:
1) A business’ working capital needs can fluctuate over its life cycle. For example, a company may become less dependent on lines if growth slows, it cuts a product line or if the company’s internally generated cash flow is sufficient to fund increases in temporary working capital.
2) Following the Great Recession, many borrowers had their line capacity reduced or eliminated through no fault of their own and were victims of their bank’s capital constraints or their bank’s standing with its regulator. The availability of commercial credit lines has since greatly improved and consequently, borrowers may have lines that they do not actually need but still want just in case cash flow tightens when the economy slows.
3) Professional firms such as attorneys or physicians often demand a line of credit in exchange for moving their valuable deposit accounts to a new bank. The lines often go unused and when they are up for renewal, the individual partners present many challenges to an account officer who needs to obtain updated financial information to properly underwrite the renewal.
4) Borrowers occasionally request large lines of credit that serve no other purpose than to satisfy their ego. Thus, lenders commonly call them “ego lines”.
5) In our efforts to grow loans and deposits in a competitive industry, lines of credit are often thrown in with other credit and deposit products to sweeten the overall package.
When it is time to renew a line of credit, there is no better time to evaluate the entire banking relationship and if necessary, recalibrate the line limit with the borrower’s past and planned usage. The banker must have an open discussion with the borrower about their growth plans, if their customers are beginning to pay late, or if their suppliers are demanding shortened terms. This discussion, along with the borrower’s current financial information, will give you solid data to determine if it is appropriate to reduce the line and if so, by how much. Of course, if there is evidence of permanent working capital kept on the line of credit, it should be removed from the line and amortized over a reasonable term. The line limit can then be reduced by the corresponding amount.
As any lender has experienced, pride often gets in the way of reasonable decision making and borrowers may negatively react to your proposal to reduce the line capacity. Obviously, the account officer must consider if the risk of losing the borrower’s deposits and damaging the overall relationship exceeds the return of requiring a lower line limit. However, the lender should not hesitate to educate the borrower of the higher expense an elevated line limit with limited usage creates for the bank.
Other than simply reducing line limits, the bank should take this time prior to a possible 2019/2020 economic slowdown to ease in other sound banking approaches at renewal time that may have been ignored over the past several years. These include inserting 30-day zero balance requirements, requiring the submission of monthly accounts receivable aging reports and mandating periodic borrower-paid third-party A/R and inventory audits.