A Brief History of Commercial Lending in the US

Before we dive into the nitty-gritty of the commercial lending process, let us look at how early US financiers assessed risk, reward, liability, and viability to decide on supporting businesses, focusing mainly on lending practices after the Civil War.

In the post-Civil War period, commercial banks, insurance companies and saving banks fuelled a ‘second industrial revolution’ by funneling the savings of their customers into America’s frenetic business activity and technological innovation. Such institutions had to make sure that their defaults were always less than their gains from interest. They identified two guiding principles to assess risk: moral hazard and adverse selection. Simply put, moral hazard is the likelihood that a debtor might merely disappear with the loan or engage in risky practices with it instead of paying it back or even using it to run a business. Adverse selection arises when any lender offers competitive interest rates – an irresponsible borrower would jump at such an offer, while the more careful ones would shy away from it because it is ‘too good to be true’.

Lenders instituted specific measures to account for both types of risk. To reduce moral hazard, banks screened the financial conduct and credit history of loan applicants, and to mitigate adverse selection, they demanded collateral, monitored the checking account of the borrower, and placed stringent conditions on what business purpose the loan would be used for.

Moral hazard and adverse selection are the precursors of today’s more sophisticated Five C’s of Credit, which we will discuss below. For present-day lenders, the 5 C’s of credit are the guiding principles that determine and inform their decisions at almost every point of the commercial loan process.

The Five C’s of the Commercial Lending Process

The Five C’s of credit – character, capacity, capital, collateral, and conditions – together decide if a business gets a loan or not, and even the terms of the loans they get. They can even be linked to the various steps in the loan application process, as we will see below. Notice that early lenders had already focussed on collateral, loan conditions, and character to mitigate risk, and today, ‘capacity’ and ‘capital’ are also considered before arriving at loan terms. We will take a look at each concept, as it is understood today, below:

• Character – Is the borrower honest, reliable, and ethical in business dealings and financial matters? Does their credit history or score – standardized to a common scale by credit agencies make the case for the borrower’s character? Credit scores issued by companies such as FICO and VantageScore detail how much the prospect has borrowed, and how much they have repaid on time for years. These do not paint the full picture, in fact, in commercial lending, loan officers will also probe the company and its management’s reputation.

• Capacity – Can the borrower repay the loan according to its terms and fulfill their other business obligations as well? Projections based on the borrower’s current cash flows and debt form part of this assessment and they are deemed risky if they are deep in debt. However this ‘C’ must take into account not only the business’s capacity to repay but also to continue operating. Loan officers will assess the business’ competitive advantage to get a sense of how it will scale and perform over time.

• Capital – Has the borrower invested a significant sum of their own money into the business? Have they earmarked funds to repay debt, or is all their capital tied up in their business? Will the borrower’s personal worth enable the bank to extract a personal guarantee on the loan? The more funds a business has at hand, the more likely it is to get a loan because the lender is assured that the business has various means to repay, including the net worth of the owner or founder.

• Collateral – Can the borrower pledge their (valuable) assets as security that can be repossessed if they can’t repay? Can this collateral be liquidated easily so that the lender loses as little money as possible? Commercial borrowers can put up multiple assets as collateral – including the money owed for their goods and services, their commercial properties, and even the equipment that they are seeking a loan to buy.

• Collateral – Conditions – What is the loan to be used for? How stable is the borrower’s industry? How well can the business weather harsh economic conditions? Lenders cannot assess borrowers in an economic vacuum. The Great Depression (1929-1939) and the Great Recession of 2008 hurt commercial lending hard, because a severely depleted economy cannot readily fund business activity.

Borrowers must satisfy multiple considerations before getting a loan. As we will see in a later section, there are many pressures, including regulatory strictures, that the lender faces during the process. For now, we will dive into the commercial lending process itself and see how it is influenced by the five C’s.

Also Check: Commercial Lending Trends

How the Lending Process Works in the US

The commercial lending process is complex not only because of the more complicated credit structure of such loans but also because of the variety of options that borrowers have to secure. We will discuss each part of the process and attempt to clarify them using the five C’s:

1. In the loan origination step, relationship officers seek out potentially viable customers, considering factors such as character, capacity, and collateral. This is the time to live up to these considerations by assessing why you need a loan, how you intend to repay it, what you can pledge to secure it, and more, well before you even apply.

2. In the client discovery step, the lending team assesses a prospect’s financial health (capacity), its specific funding needs (capital), and how the loan can be structured and priced (collateral considerations included). Seek out favorable lenders just as lenders seek out good prospects, and target those with favorable terms.

3. It is now time to prepare your documentation, including a business plan that crafts a compelling case for funding your venture, statements that reflect your financial health, and legal permits, licenses, and articles of incorporation to show you are a legitimate business. This is where you make the case for character and capacity.

4. Once you go ahead with the formal application, the lender begins the process of analyzing and underwriting your credit request. This is a step where all the C’s are considered in general and the creditworthiness of the borrower in particular. Lenders must go through loan applications with a ‘fine-toothed’ comb, as it were, looking into:

   • The business’ age, collateral, expertise, and industry risk, and even the personal credit of its founder/owner

   • The company’s financial data indicates its capacity to repay the loan while fulfilling its business obligations

   • Whether the loan and the business are a good fit for the lender – for example, an equipment financier will readily finance a similar loan, and a credit union might choose to support businesses owned by members of the community in which the unions operate. A Small Business Administration loan can be given only to business owners whose credit scores are 600+ or higher and who can establish they cannot secure loans from traditional funding sources

   • The loan amount: the lending team may be authorized to lend up to a certain ceiling, above which it may need to refer the application to a senior credit officer or loan committee.

   After this scrutiny, the lending team, or the senior loan committee will approve the credit structure of the loan.

5. The lender and borrower sign a loan agreement – that serves as legal recourse for both parties – after negotiations. The agreement itself describes in detail loan terms such as:

   • The loan amount, its interest rate, any fees involved, how it will be disbursed and over what period, etc, and in commercial loans, which may contain multiple bundled loans for various business purposes, each loan has its own terms.

   • The collateral is usually included in the contract, but can also be registered in separate agreements if multiple loans are involved.

   • Reporting requirements that the borrower must fulfill, especially for commercial loans where the lender may require periodic updates on the business’s financial health.

   • Covenants that prescribe specific actions that the business must take. A basic example is limiting the dividends that a business can pay to its shareholders to ensure that it has sufficient cash (from revenue) to keep up with its payment schedule.

   • Default clauses outline what action the lender will take if any covenants are broken or reporting requirements are not met. Defaulting may usually accelerate the repayment schedule.

   • Warranties and representations, where the borrower must state that tax payments are up-to-date, the business’ health has not worsened since it was assessed while determining the loan structure, and other guarantees.

6. Once the loan agreement is signed, the lender ‘perfects security’, or takes legal steps to protect its right to collateral, specifically the right to repossess collateral, against any third parties (excluding the borrower).

7. Finally, after all these steps, the loan is advanced. Disbursement depends on the loan type: a term loan will be transferred as a lump sum as it will be used to buy high-cost equipment or lease office premises. A revolver, or line of credit, allows a business to borrow funds as and when it needs quick cash to operate, and it can draw on this line of credit again after repaying.

Commercial loans are far more complicated than personal loans for the obvious reason that assessing the health of an entire business, along with the credit of its founder or owner is more complex than sifting through an individual’s tax records and credit history. Businesses may need different types of loans to operate – for example, a term loan to lease corporate premises, and buy equipment.

This is why commercial loans are flexible – in the above example, the lender might accept the equipment itself as collateral but may require an asset of comparable value for the corporate lease. However, this flexibility makes such loans more complex, which is why it is best to agree with legal counsel’s supervision so that both the lender and the borrower understand not only their obligations but also their legal protections in case of a breach.

Also Check: Commercial Lending in the USA

How the Process Impacts the Commercial Lender

The legal aspect of commercial lending brings us to the challenges faced by lenders – until now, the five C’s and the loan process itself can be seen as the various criteria that the borrower must live up to in order to qualify for a loan. But what about lenders? The challenges faced by lenders are explored in more detail in our blog on commercial lending trends, so we will look at only two major challenges, in brief:

1: The Regulatory Minefield

Until recently, commercial lending was not regulated at the federal or state level, unlike personal loans, which were rigorously regulated and have, for decades, fallen under the unifying rubric of the federal Truth in Lending Act of 1968. Commercial lending, however, is now subject to a thicket of regulatory structures unique to each state, requiring state-specific disclosure statements – and this may compel smaller lenders to scale back their operations and stop funding the very businesses that these laws seek to support. Only lenders that can afford to hire compliance staff or adopt ‘Regtech’ can operate without scaling back

2: The Technology Gap

It may seem like the lender is in a privileged position in the commercial lending sphere, requiring all sorts of disclosures and virtues from the borrower. This is not the full story. Customers today are used to technology mediating – and optimizing – every aspect of their lives. Younger business owners expect this even when seeking a commercial loan, with flexible terms, personalization, and dashboards that clearly spell out their financial obligations. Today’s borrowers will simply resort to neo-banks or peer-to-peer lending platforms if traditional lenders do not keep up with the (digital) times.

Other challenges include the rise of ESG (environment, social, and governance) principles in investing, which pressure lenders into backing potentially risky green ventures while under strict regulatory oversight. Unlike the SBA loan, which has had more than seven decades to cement its stringent criteria and protect both lender and borrower, sustainability-linked lending is still a nascent and potentially volatile space. Finally, record-high interest rates are making it hard for any lender to provide competitive terms to borrowers.

Conclusion

Commercial loans are inherently complex because they fund businesses and not people. Sound commercial lending practices have propelled the US economy into boom times, and predatory lending practices (like the home loans that led to the sub-prime mortgage crisis) or irresponsible speculation by banks (that precipitated the Great Depression) have brought about the worst economic downturns in US history.

Right now, what constitutes sound lending practice is complex beyond measure, both for the borrower and the lender. If the borrower has to jump through multiple hoops, the lender must fulfill multiple obligations, and both still have to reach common ground amidst high interest rates and regulations that either hurt the very businesses they try to protect, or direct investment in uncharted territory such as sustainable lending.

Given this situation, technology cannot be adopted piecemeal to address the challenges faced by borrowers and lenders alike. Rather, lenders should invest in end-to-end solutions such as Finanta so that they are armed and ready for the (technologically)-enhanced future.