Jeff Judy

Jeff's Thoughts - November 1, 2017

More on "Second Order Thinking" About Credit

In the previous issue of Jeff's Thoughts, my topic was "thinking about thinking." In particular, I addressed those bits of thinking that are done and codified -- such the credit policy manual -- and don't get much rethinking until something obviously goes wrong. My own thinking was stimulated by an article on "second order thinking" in banking, written by Chris Nichols.

In this issue I'd like to shift our focus from the broad picture -- credit policy, procedures, software algorithms -- to the thinking involved in the analysis of an individual credit request. One of the reasons that article caught my eye is that I have spent decades advising and training relationship managers and credit analysts and other credit staff on how to think about credit.

Thinking about a credit request goes in stages. We start with "What?" thinking. First, what are the basic numbers? What has the borrower given us for sales, expenses, debt, and so on?

The next step in thinking about the request is another layer of "What?" thinking, but at this level, most of the thinking is done by machines. What does initial financial analysis spit out for cash flow, or leverage, or ROA? What trends does the common sizing of past statements reveal?

Unfortunately, all too often this seems like enough thinking to make a decision. We have ratios, we have thresholds, and a simple comparison points toward an approval or a decline. But there's a lot more thinking to be done if we want to approve and structure credits that will benefit our portfolio over the long haul.

Now we get into "Why?" thinking. Why are those analysis numbers what they are? The goal here is to identify the events and factors that could make those numbers better, the ones that could make them worse, and the relative probability of those events occurring during the life of the credit.

And within that "Why?" question there are a couple of levels of thinking. The first is about external events. What could happen in the marketplace that could impact the borrower's numbers? For example, if you are dealing with a small- to medium-sized retailer, is there any news of a competing big box store coming in in the near future? Or perhaps you are working with a business that could benefit from the enthusiasm for deregulation to be found in many industries these days.

But don't stop with these events. Business results don't arise directly from external events, but from the responses of management to those events. Some smaller retailers do okay when the big box stores come in, but others go extinct when their owners just assume their great service in the past will ensure continued customer loyalty. And responding to deregulation can be tricky, especially in a time when customer and public reactions can snowball on social media so quickly. Just because a business can do something it couldn't do before doesn't mean that doing it is a good long term strategy.

Indeed, the real test comes when you bring these higher-order questions to your borrower. When you discover that your borrower has not really thought about how to respond to likely events, when they have no idea why the numbers are what they are and how their actions could change them, it is time to be more cautious. Getting at the "Why?" of their recent results reveals a lot about management capabilities and priorities, and may affect not only the approval decision, but how tightly you structure the credit, the covenants you require, and so on.

Numbers are great. Reasons for numbers are even better. Take the time to apply higher-order thinking to your relationships, and both you and your borrower will benefit from the discussion.