The Art of Safe Lending: How to Mitigate Commercial Loan Underwriting Risks

October 26, 2023

By: Ollie Sutherin, Principal of Y&A Credit Services

Community financial institutions have long been known for their agility and personalized service, excelling at creating unique lending solutions and facilitating distinct transactions. However, the very attributes that have set them apart may now present fresh challenges as they seek to expand. Community banks and credit unions find themselves navigating a delicate equilibrium: effectively managing underwriting risk, diversifying their loan portfolios, and growing to better serve their communities. 

Additionally, the world of commercial loan underwriting presents its own distinctive challenges that further complicate finding this equilibrium. Commercial loan underwriting standards, in particular, are designed to foster relationship banking rather than transactional interactions. Loans are underwritten based on the borrower’s anticipated ability to operate their business profitably and service the debt being requested. However, the actual cash flows of borrowers can often deviate from expectations, and the value of collateral securing these loans may fluctuate. Most commercial loans are secured by the assets they finance, along with other business assets such as accounts receivable or inventory, and sometimes entail personal guarantees. Loans secured by accounts receivable heavily rely on the borrower’s ability to collect due amounts from customers. These complexities create a web of considerations for underwriters. 

Effective management of a community financial institution’s loan portfolio necessitates a strategic approach guided by skilled underwriters who play a pivotal role in mitigating underwriting risks in commercial lending. 

The After Effects of the SVB Collapse 

A little over six months have passed since the financial world experienced a seismic shift when a prominent regional bank collapsed. This event sent shockwaves throughout the banking sector, triggering a chain reaction that affected numerous other financial institutions, both regional and local. These far-reaching consequences have also left their mark on various aspects of community bank and credit union operations. 

Risk management has always held a pivotal role in credit underwriting, and its significance has become more pronounced in today’s ever-volatile environment. As we navigate an era of monetary tightening, global inflationary pressures, and increasing interest rates, underwriters find themselves under increased scrutiny. In the past, cheap funding was abundant, but now, risk-appropriate pricing is paramount for funding new deals. Underwriters must balance a new interest rate environment with the heightened lending and refinancing risks, necessitating increased diligence in risk assessments when extending credit and negotiating terms. 

To shed light on this matter, we will explore effective strategies for community financial institutions to limit underwriting risk in commercial lending, ensuring they can thrive while maintaining a prudent approach to lending.  

Comprehensive Credit Analysis 

The cornerstone of any sound underwriting process is conducting a comprehensive credit analysis. This involves digging deep into the current financial health of the borrower, their business, and the industry they operate in. By meticulously assessing factors like cash flow, collateral, and credit history, you can gain a clearer picture of the borrower’s ability to repay the loan. 

Moreover, consider working with an experienced outsourced credit underwriting service like Y&A Credit Services to ensure you have access to the latest data, analytical tools, and expertise in evaluating commercial loans. Our team of experts can assist from reviewing your analysis to completely underwriting the transaction, ensuring you have all the information to help you make informed lending decisions. 

Diversification of Loan Portfolios 

Diversification is a risk management principle that rings true in commercial lending as well. By diversifying your loan portfolios across various industries and business types, you can reduce your exposure to sector-specific risks. A balanced mix of loans in manufacturing, real estate, healthcare, and other sectors can help buffer your institution against economic downturns that may affect a particular industry. 

Loan Covenants and Monitoring 

Establishing clear and enforceable loan covenants is another key step in limiting underwriting risk. These covenants set out the terms and conditions under which the borrower must operate and repay the loan. Regularly monitoring the borrower’s compliance with these covenants and requesting the most current information from your borrower is equally important. It allows you to detect early warning signs of financial distress and take corrective action sooner when you have more options for a successful outcome for both your borrower and your institution. 

Loan Portfolio Stress Testing 

In an ever-changing economic landscape, stress testing is an invaluable tool for gauging how your loan portfolio would perform under adverse conditions. By modeling various scenarios against your portfolio, you can assess your institution’s vulnerability to economic shocks and make proactive adjustments to your lending practices. 

Ongoing Training and Education 

Staying up to date with the latest industry trends, regulations, and best practices is essential. Encourage your staff to engage in ongoing training and education programs related to commercial lending and underwriting. This ensures that your institution’s underwriting processes remain current and effective. 

Regular Commercial Loan Underwriting Reviews 

To maintain the health of your loan portfolio, it’s crucial to conduct regular reviews of your commercial loan underwriting practices. This ensures that your institution’s standards and processes align with the evolving landscape of commercial lending. It also allows you to make necessary adjustments and refinements to minimize underwriting risks continuously. 

Outsourcing Commercial Credit Underwriting 

Third party assistance for commercial credit underwriting can be a strategic move to ensure the accuracy and effectiveness of your underwriting processes and relieve your institution of the need to maintain an up-to-date full-time staff.   Professional outsourced services, like Y&A Credit Services, offer expertise, access to advanced analytical tools, and an impartial perspective, helping your institution make sound lending decisions and maintain high underwriting standards.  These services can be implemented from fully outsourced to fractional, helping assist during peaks in volume.  

Y&A Credit Services’ Guidance in Commercial Underwriting 

Mitigating underwriting risk in commercial lending stands as a pivotal cornerstone for upholding the financial health and stability of community banks and credit unions, especially in the wake of the industry upheaval earlier this year. By implementing comprehensive credit analysis, diversifying loan portfolios, enforcing loan covenants, conducting stress tests, and investing in ongoing training, regular reviews, and outsourcing, you can confidently navigate the complexities of commercial lending while minimizing risks and enhance your institution’s lending capabilities. 

At Y&A Credit Services, we understand the importance of risk management in commercial lending, and we’re here to guide you through the process. Our outsourced credit underwriting services are designed to provide community banks and credit unions with the expertise and resources needed to make sound lending decisions. Together, we can build a more secure lending future for your institution, helping our communities one loan at a time. 

Contact us today to learn how we can help. 

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