Oct 21 2018
Credit analysts at commercial banks face a tremendous amount of pressure on a daily basis. Increasing regulations, shareholder pressures and scrutiny from bank executives compounds the difficulty of tracking bank mergers, acquisitions and shifts in portfolio focus. It is a frantic situation, made more complicated by the fact that good credit analysts should demand accurate company financials, reliable industry benchmarks and confident risk assessment, all while remaining committed to the bank’s particular risk appetite.
Fortunately for these individuals, help is available: The North American Industry Classification System (NAICS) sets the industry standard for analyzing and classifying companies, and NAICS-based research provides credit analysts with the ammo they need to mitigate risk and compare potential clients with industry benchmarks.
Conditions, Capacity and Character
Many banks are returning to the fundamental “five Cs” of credit. Specifically, banks use industry research to satisfy the conditions component of the five Cs. Conditions are defined as the economic factors outside a firm’s control. As such, any credit analyst would agree that fully explaining an industry’s key drivers, supply chain connections, risks and opportunities an be a daunting task. In order to be efficient and effective, credit analysts increasingly are turning to NAICS-based industry research to aid their evaluations.
Credit analysts also evaluate industry research when explaining the capacity portion of the five Cs of credit. Capacity establishes a borrower’s ability to repay a loan based on the borrower’s business plan and cash flows. Using industry research, credit analysts are able determine if the borrower is doing what it takes to survive. Understanding why an industry exists and its potential successes or failures can help the credit analyst make an accurate assessment when determining the bank’s willingness to engage in the loan agreement. Such research also discusses the industry’s key success factors and drivers to explain how winning businesses operate.
In addition to recommending or rejecting loan applications, credit analysts also advise the bank’s relationship managers on how to restructure loans to better fit the bank’s risk appetite. If the borrower is underperforming compared to industry benchmarks, the bank may not make the loan. Likewise, if an existing client’s risks increase, the bank can address and mitigate these risks by getting more collateral or restructuring the loan.
An important aspect when analyzing a client is spotlighting the structure of the industry in which it operates, specifically purchases. Depending on the industry, purchases many times can be used as a proxy for other forms of collateral that can quickly be turned into cash for a loan payment. Purchases and profitability also tie in closely with another credit principle: capacity. Once again, the credit analyst can compare the cash flows of their client with the NAICS benchmark.
At some banks, credit analysts assist bankers with client meetings. By attending meetings with the relationship managers, analysts can get a feel for the character component of the five Cs.
Third-party research gives credit analysts an understanding of how operators succeed and it arms them with conversation builders surrounding internal management issues. Such research also helps analysts explain why the borrower’s business plan fits market demand (or not) and how the operator can combat external sensitivities, e.g., fluctuations in personal disposable income for retail operators.
Strengthen Internal Partnerships
Beyond assisting individual credit analysts in their day-to-day evaluations, NAICS research helps create partnerships within a bank’s internal operations. Once the relationship manager and credit analyst source the same data, they will use the same baseline when assessing lending opportunities, thus streamlining the credit application process
In addition to relationship managers, credit analysts also work closely with a bank’s portfolio managers. Portfolio managers often provide advice to credit analysts based on risks specific to a NAICS industry, and many banks have developed a system to inform credit analysts of industries to which the bank refuses to lend. For example, a bank can develop a simple check-box system that evaluates the potential risks of lending to an industry, and portfolio managers can then use industry risk scores to place each industry into buckets ranging from very low to very high industry risk. Further, the trend of the risk scores can be defined as increasing, steady or decreasing. Using this information the credit analyst can explain how borrowers might mitigate potential risks in industries that may have a higher risk level or increasing risk trend.
An Example Based on NAICS Research
Consider the home improvement store industry (NAICS 44411). On initial inspection, home improvement stores are typically sound. The industry is in the mature stage of its life cycle and maintains steady revenue, but, looking deeper, the industry is exposed to some highly risky external sensitivities. Industry research suggests that the greatest potential opportunities or threats to industry operators are: the level of per capita disposable income, consumer sentiment and the number of households in the market. These industry variables can have a great impact on the success or failure of industry operators. Using a scoring methodology based on a one-to-nine scale, (with nine as the highest risk) the greatest external sensitivity affecting the industry is per capita disposable income.
Competition presents another potential industry-based concern for the bank to consider. Home improvement stores are in a highly competitive market in which the top two players, Home Depot and Lowe’s, generate more than 70 percent of total industry revenue. If the borrower is an independent home improvement retailer, the credit analyst will need to describe how the operator will compete while lacking the robust distribution channels and economies of scale that benefit the major players. When reviewing loan applications and credit memos, the credit analyst also will need to describe how the potential borrower’s business plan mitigates the inherent risks of operating in an industry that is so highly dependent on the success of the overall economy.
While the pressures facing credit analysts are unlikely to disappear, third-party NAICS research can solve many of the fundamental problems they encounter in their daily evaluation routines. By grouping industry research, risks, competition and historical benchmarks (conditions) with the client’s character and capacity, credit analysts are able to more accurately predict the repayment success of loan applicants and existing borrowers.
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