Credit Memorandum Best Practices and “The 5 C’s”

Credit memos can be simple yet provide a road map to help someone other than the loan officer understand the nature of the credit. Below are the “five C’s” of credit that can be used in the underwriting documentation. These principles have existed for years but aren’t always applied in the documentation. However, by including each of these elements in your credit memo, you can meet regulatory requirements and assist in monitoring credit risk.

Character

What is the Bank’s history with the borrower?

This should include previous credit performance with the bank or the borrower’s history with the lender at other institutions if the officer is new to the institution. Information such as the credit score, past due history, public records can help evaluate the borrower’s character. Finally, the deposit history should be evaluated and included; if the borrower has a history of overdrafts and NSF items, this information should be noted. The credit risk increases the more problems a borrower has shown in the past.

Capacity

How is the borrower planning to service the debt? 

Documenting the ability to service the debt as agreed is critical. For consumer loans, it is common to calculate debt-to-income (DTI) ratio considering current debt load, additional debt, and current earnings. Commercial loans generally utilize the debt service coverage (DSC) ratio. Cash flow, or earnings before interest expense, taxes, depreciation, and amortization (EBITDA), should be calculated and documented based on the past 3-5 years of tax returns or financial statements. Pro forma information can also be considered (such as expected future earnings). Current debt payments combined with new debt should be included. The closer the DSC ratio is to 1.0x or the higher the DTI ratio is, the more the risk increases for the credit.

Capital

How much additional liquidity does the borrower have?

If the borrower has problems generating cash to service the loan in the future, do they have enough cash on hand to supplement income shortfalls? Documenting cash held in the institution is important. Cash and investments are noted on the most recent tax return or financial statement and total liquid assets at the time of approval. The more capital a borrower has the less risk to the institution.

Collateral

What assets secure the loan?

If the loan defaults and the bank repossesses the collateral or if the borrower must sell the collateral to repay the debt, it is necessary to document the asset’s value and loan-to-value (LTV) ratio. For real estate loans, the basis for the valuation should be noted; ensure value aligns with the interagency guidance for real estate appraisals. For purchase money loans, document the purchase price and present loan-to-cost (LTC). Whatever secures the loan, notate if the LTV/LTC is within or outside of policy. The lower the LTV/LTC ratio, the more skin the borrower has in the collateral, thus reducing credit risk.

Conditions

What are the terms of the loan? 

Document the origination amount, maturity date, interest rate (fixed/variable, index, spread, floor, ceiling), amortization schedule, call code, risk rating, and more. If there are covenants, clearly explain what is required and how those will be monitored. Sources and uses of the loan proceeds also provide good information about the purpose of the loan. Terms that are unusual or outside of policy increase the credit risk of the loan. Furthermore, this is an excellent opportunity to evaluate if the rate earned is in line with the risk assumed.

CRI’s financial institution professionals have extensive experience in providing value-added consulting services to community banks across the southern United States. Contact us today to learn how we can assist your team with best practices in credit memos for your next examination or review.