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The Changing Nature of Your Banking Relationship … Some Ideas to Consider

Mark Robertson, practice leader of Blackman Kallick’s Lender Support Services team, recently offered some observations on how the current banking environment might affect your relationship with your bank. We thought it worthwhile to share these insights with you.

The ongoing credit crisis, and now the economy in general, are continuing to take a major toll on the banking industry. Many now think the problems in the banking sector are becoming worse than previously predicted, and the list of troubled banks grows almost daily. All of this turmoil is having a major impact on the availability of credit to all but the most creditworthy borrowers. Some say that credit is being made available only to those who clearly do not need it.

Because of the nature of its work, Blackman Kallick’s Lender Support Services Practice has firsthand knowledge of how banks are treating potential and existing clients who are looking to extend their lines of credit. Below are a few key areas for you to consider over the next few months.

Your bank contacts might be telling you that banks are lending, but it is important to understand that lending terms have changed dramatically. As you are well aware, gone are the days, at least for now, of granting credit to nearly any borrower at ultra-low rates. Borrowers are now faced with tougher underwriting requirements, likely higher interest rates and fees, and greater scrutiny before and after the loan is funded. Even companies who are performing relatively well will most likely feel the effects of the changing world of banking. Please note that banks must still adhere to the loan terms, but even minor covenant breaches and certain borrower requests can trigger a bank's right to impose stricter demands. Now, more than ever, companies need to have a thorough understanding of their loan agreements.

Expanded Risk Management Programs and Additional Oversight Various regulators are paying much closer attention to the controls banks have in place to monitor and evaluate the risk of all of their credit, and the new federal administration is already calling for greater regulation and oversight of the financial sector. These tougher standards will inevitably trickle down to borrowers. Banks’ outside auditors are putting most of the banks’ assets under a microscope and are focusing more closely on risk management, internal controls and valuation. This increasing pressure from outside auditors is driving many banks to increase requirements on borrowers regarding both the amount of and speed with which information is reported. Banks are also increasing the amount of oversight placed on each borrower.

For new and renewal loan facilities, companies might be subjected to reporting financial results more frequently and sooner than in the past. This reporting might include monthly rather than quarterly reporting with a due date 15 days after month-end. Obtaining borrowing base certificates more frequently is also a possibility. For example, some borrowers in higher risk industries might be required to report weekly, and borrowers in any level of distress might face daily reporting requirements. Increasing the frequency and timeliness of financial reporting is designed to give the bank as much advanced warning as possible of deterioration or distress in the business. This allows the bank to mitigate potential loss exposure.

We are seeing more banks beginning to take a keen interest in management's forecasts for business performance going forward. Expect banks to start looking at various levels of forecast from short-term (13 weeks) to six and 12 months with increasing levels of detail the shorter the forecast period. The sudden and dramatic decline in the real economy means that much of the historical trend analyses are of little value in determining future credit risk. As a result, bank underwriters are looking to current forecasts to gain a better assessment of a borrower’s potential risk. Companies should expect to be asked for forecasts and budgets as well spending actual face-to-face time with bankers, and possibly underwriters, to explain their business plans. Bankers might challenge these forecasts and push back on areas where they think the borrower is being overly aggressive. Remember, bankers and underwriters see many companies in the same industry and likely see how others forecast. Again, this is designed to give the banks a basis to measure potential risk and allow for mitigation on the part of the bank.

Finally, many banks are requiring more frequent field exams. Annual field exams might now be due on a semiannual or even quarterly basis. Some banks are taking steps to place stricter requirements on new loans and refinancing. Audited financial statements could now be required where a review was acceptable in the past. The costs of these additional services are generally borne by the borrower—adding another layer of expense to any financing arrangement. In more distressed situations, borrowers can expect to be pushed to hire a consulting firm to assist in evaluating and restructuring their business. Such consultants could cost $10,000 or more per week.

Possible Refusal to Forbear, Refinance or Renew Diminished capital at many banks is driving these banks to reduce the total risk profile of their portfolios. One way to reduce risk is to force less-desired borrowers “out of the bank.”

It is important to understand that banks might be looking to reduce exposure to certain industries, credit risk profiles, loan types or borrowers who do not generate enough profitable fee income. So, a borrower who appears to be doing fine might still be pushed to find a new banking relationship.

Pushing a borrower out of the bank is most easily accomplished when an existing loan matures. The bank may simply refuse to renew the loan or it may offer a renewal on terms that are unacceptable to the borrower.

During the term of the loan, a bank might force a borrower out of the bank when a borrower breaches any loan covenant, no matter how small. Typically, certain covenant breaches allow the bank to call the loan on very short notice. Banks generally have the option to enter into a forbearance agreement in the event of a breach. However, a bank is not necessarily required to offer such a concession to the borrower. Companies should understand this risk in advance and avoid any breaches of loan covenants, no matter how minor they might seem (e.g., financial reporting due dates). In addition, companies that know they might breach a covenant should consider starting negotiations with their bank as early as possible (i.e., before the breach occurs). Being proactive with banks tends to yield better results than waiting until the situation has reached a near crisis point. When multiple banks are involved, expect the timeline for negotiations to be even longer.

Finally, keep in mind that a bank is likely to charge a fee for any forbearance agreement. The purpose of this fee is to compensate the bank for the additional perceived risk they are accepting by agreeing to lesser terms. These fees are usually in the range of 1% of the loan amount plus the bank’s costs (i.e., legal fees). With some advance planning, covenant breaches can be managed and possibly avoided by taking certain steps to manage the business’s finances effectively. However, this is only possible with proper planning and analysis.

Reductions in Loan Limits and Advance Rates Another tactic many banks employ to reduce risk exposure is to reduce the total limit on a loan facility (e.g., a $2 million facility might be cut to $1 million). This tool is often used when a borrower has historically maintained significant excess availability on their line. Cutting the loan limit reduces the bank’s technical exposure without directly forcing the borrower to find a new bank. This is commonly seen in situations where the borrower is performing relatively well, but the bank needs or wants to reallocate its use of capital. While reducing an unused portion of the line might not seem like a big deal, it can have a serious impact on the company if the company planned to use such excess availability for strategic purposes or as a financial safety net during the economic downturn.

Lowering of advance rates on asset-based loans is a way for banks to reduce loss exposure by decreasing the loan to value ratio (e.g., cutting an 85% advance on accounts receivable to 80%, 75% or lower). In the current economic environment, many banks are reducing advance rates on many types of loans from the obvious (real estate) to the less obvious categories of machinery and equipment, inventory and accounts receivable. These reduced advance rates are intended to protect the bank from possible declines in collateral value after funding the loan. In a deteriorating economic environment, the collateral values are at risk for a variety of reasons including general declines in value (real estate, machinery and equipment, inventory) and customer bankruptcy (accounts receivable, inventory). Along with lowered advance rates, banks will typically expand the types of ineligible assets (for accounts receivable and inventory) to include a much broader range of accounts and inventory items.

Lowered advance rates and increased ineligible items both have the effect of less available credit to the borrower and could have a very serious impact on working capital. There are steps companies can take to mitigate some of this risk to their assets, specifically accounts receivable and inventory. Banks like to see borrowers proactively taking such actions as this might work to protect the company’s ability to borrow at historical advance rates. In addition, actions can be taken to better manage working capital and potentially reduce a company’s borrowing requirements.

The time to act and ask questions is now. While you might be concerned about opening a dialogue with your bank, it is almost certainly wiser to start asking questions now as opposed to being surprised later. It is recommended that you open up the discussion with your bank at least four months prior to the date(s) your line(s) come due.

But first, some questions to ask yourself. Are you prepared to provide a rolling cash flow forecast to your bank?

Do you know what your loan covenants are, and do you have a plan in place to make sure that you are in compliance with them? Are you prepared to engage in a proactive, rather than reactive, discussion about any anticipated problems?

Do you know how your bank will treat your overall credit line the next time it comes up for renewal? Have you had a conversation with your banker recently regarding advance rates and their perception of the underlying asset quality?

Need some assistance? Blackman Kallick’s Lender Support Services team can help you work your way through these questions and issues. For more information and guidance, please contact Mark Robertson directly at 312-980-3263 or mrobertson@BlackmanKallick.com.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.