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If character is #1 "C," then what is #2?

The answer is also a community bank fundamental

Bankers are trained as an article of faith that Character is the top C of Credit. If we all agree that this is so, the next question is, which of the other four comes in second?


Not all Cs are alike

It may never have occurred to you that the Cs of Credit, that list of principles on how to lend money, have active and passive aspects.


The passive aspects, at least to me, are reflected in Collateral and Capital.


They are deal points, to be sure, but a little more or less of either seldom spells the difference between a favorable vote in loan committee or a turndown.


The active aspects--the "juice" to most bankers--lie in Character, Conditions, and Capacity.


If business conditions are lousy and negatively impacting the availability of credit and the banks' overall willingness to lend, that's an important if not determining variable. So is the Character of the borrower.


But what about Capacity? 


Is that the #2 C of Credit? 


Without Capacity, you don't have a viable loan

Capacity is the perceived ability of the borrower to accomplish his business plan and execute as anticipated on his loan repayment program. Without a lender's confidence that the borrower can execute, then the loan request draws a "no" regardless of collateral, capital, or business conditions.


Not all lenders seem to be able to lend money with the same success. Some bankers misjudge the customer's character and willingness to repay, take too favorable a view of economic conditions, or place too much reliance on collateral.


Capital is a factor but to access a borrower's capital as a source of repayment requires a conversion of one or more business assets into cash.


So, that leaves Capacity as the determining C of credit.


And that is something that we bankers can be proactive about influencing and nurturing.


Capacity is what propels a repayment program. That, to my thinking, makes it clearly the #2 C of Credit to most lenders.


The banker's job--check it out

But how, then, do lenders influence capacity?


First, capacity to repay has to be perceived by the lender. The lender, in turn, usually has to convince others within the bank of the borrower's ability to repay.


(I deliberately exclude collateral from this discussion as I am assuming that no one will deliberately make a loan where the primary source of repayment is the liquidation of collateral.)


There is a term describing a process that all lenders learn starting with the first day on the job and that term is "due diligence." 


We do our due diligence on everything, all the Cs of Credit and the better the job of due diligence, the almost invariably better the result of our lending activities.


Due diligence properly and thoroughly done can turn up indications of Character both positive and negative.


We learn about Collateral--where it is, what it's worth, and how to perfect our security interests. Our analysis helps us assess the extent of equity on the borrower's balance sheet and causes us to inquire on the nature and liquidity of the borrower's assets and liabilities.


Business Conditions are probably something we all tune in on as part of our jobs. We operate in much the same environment as our customers are and feel many, if not most, of the same stresses and strains on a daily basis.


Capacity, though, is something else.


It's "how the deal works" insight.


And without that, no credit can be properly understood or evaluated.


Looking back: capacity in the real world

Have you ever watched a young (or perhaps a not-so-young lender) presenting a loan to committee and had the realization that he or she really didn't understand how the deal worked? 


That's happened to me more than a few times, particularly during the few years that I was chairman of the senior credit committee of a large regional bank in Oklahoma.


I even remember when I was the perpetrator--as a new lender with almost my first deal to committee many years ago. Fortunately, the deal was declined in spite of my positive recommendation. Then I watched from the sidelines months later as the company collapsed due to an accounting fraud.


What makes this embarrassing to recall is that the accounting fraud was in my power to diagnose and see. But my own due diligence process was superficial and, well, just stupid. I could today retreat into my reverie and say that was a long time ago but really, I could have seen it and should have seen it, but didn't. My fault.


So much for a borrower's Capacity if the lender doesn't understand it or hasn't investigated it fully. We're seeing more sunshine on this particular problem in recent years in the form of stress testing of credit. So as an industry, I guess we understand that our analysis about a borrower's Capacity has limitations. This is an example of how we must be proactive on this aspect of credit underwriting.


Another path to knowing Capacity

There's another way that we can help too and it's part of what bankers do, good ones at least, and have always done. We function as informal consultants to our customers and become extensions of their eyes and ears in our own separate environments with our portfolios of borrowers. We also soak up a lot of valuable information on structure, strategies, and techniques in credit committee when we participate in discussions on the deals of others.


Now, don't misunderstand what I just wrote.


Recall that I've said in the past that bankers have no business telling our customers how to run their businesses. And we cannot and should not prefer our bank's interests over the interests of any of our customer's other creditors.


But what a shame if we bottle up information of value to our customers because of a fear or reluctance to share useful information.


This denies our customers a source of due diligence and independent information for their businesses and in the process, may weaken their own capacities as owner/managers to execute their plans for the benefit of their businesses including us a creditor.


Local knowledge and understanding of business conditions is one of the prime competitive advantages that community bankers have.


We are locally based and oriented. This has value to many of our customers and prospects.


We do our communities and our customers a disservice if we deliberately remain silent and don't share our knowledge and experience, particularly when asked.


Ultimately, lenders ply their trade with success when they exercise thorough and appropriate due diligence on their borrowers' plans and activities.


Nowhere are these skills better used to greater effect than on the analysis of a borrower's capacity to repay his loan. And these insights are leveraged and magnified when shared with the customer in an insightful and helpful way.

Ed O’Leary

Banking Exchange Contributing Editor Ed O'Leary, a veteran lender and workout expert, spent nearly 50 years in bank commercial credit and related functions, working with both major banks as well as community banking institutions. His last job before retiring was as the CEO of a regional bank headquartered in Alburquerque, N.M. He earned his workout spurs in the dark days of the 1980s and early 1990s in both oil patch and commercial real estate lending. O'Leary began his banking career at The Bank of New York in 1964, and worked at banks in Florida, Texas, Oklahoma, and New Mexico. He served as a faculty member and thesis advisor at ABA's Stonier Graduate School of Banking for more than two decades, and served as long as a faculty member for ABA's undergraduate and graduate commercial lending schools. Today he works as a consultant and expert witness, and serves as instructor for ABA e-learning courses. You can e-mail him at [email protected]. O'Leary's website can be found at

In mid-2016 O'Leary's "Talking Credit" blog received a bronze excellence award for the Northeastern Region from the American Society of Business Publication Editors.

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