Now that we have digested the fact that most banks’ loan portfolios are weaker today than they were two years ago, it’s a good time to review a few of the basics of commercial lending.

To do so, let’s first acknowledge the need for community banks to return to the most fundamental of banking models: gathering deposits from within local communities and leveraging them to make loans within those communities.

It’s clear now that many of the more non-traditional lending practices that had become commonplace – from subprime and Alt A loans to more relaxed lending standards – were direct contributors to the financial crisis and credit crunch that have dealt such a crippling blow to the economy, as was the heavy reliance of some banks on non-core funding.

Consider these 10 commercial lending fundamentals underscored by the financial crisis:

1. Return to the 5 Cs of credit. There’s no better place to start a discussion of back to basics than by returning to what have traditionally been considered the bedrocks of lending: an emphasis on borrowers’ character, capacity, collateral, capital, and current market conditions. A close look at the troubled loans in any bank’s portfolio will likely reveal exceptions made to underwriting guidelines that started with the lender ignoring one or more of the 5 Cs of credit.

2. Remember the importance of risk-based capital. In March, the federal government undertook an extensive examination of 19 of the country’s biggest banks, conducting stress tests to determine the adequacy of their capital levels. This unprecedented measure underscores one of the many lessons that can be learned from the financial crisis: Capital matters.

As a result of the stress tests, the fed instructed a number of the big banks to bolster their capital levels. Given this, regulators may also require community banks to maintain higher capital levels. This will restrict banks’ ability to lend and may crimp returns in the short term, but should ultimately lead to wider margins.

3. Don’t downplay the role of confidence and liquidity. At the root of all the problems that have emerged in the credit markets is a lack of liquidity. The liquidity crisis is a direct outgrowth of counterparties no longer trusting each other – and when confidence and liquidity dried up, the market collapsed.

4. Don’t ignore risk. Risk can be disguised, but it never disappears. Financial engineers convinced many that risk could be quantified, but we forgot that the financial models assumed there would always be a market that would substantiate the value of assets. When markets disappeared, asset values crumbled. The lesson: You can slice, dice and sell risk, but that doesn’t make it go away.

5. Beware of covariance. Many community banks that weren’t directly involved in sub-prime and Alt A lending learned the hard way that they weren’t necessarily shielded from the risks these types of loans posed.

For example, some banks active in acquisition and development (A&D) and construction lending lost sight of the fact that their takeout was a subprime, Alt A or jumbo loan. The collapse of the residential real estate market had a direct and adverse impact on their builder and developer portfolios.

6. Identify your total risk exposure with each borrower. A borrower’s exposure to risk may go beyond his or her loans with your bank, especially builders and developers. Therefore, you should be sensitive not only to the risk posed by loans in your own portfolio, but also to borrowers’ other projects – or in other words, to your total risk exposure. While your loans may be performing, a borrower’s projects and loans with other banks may be faltering, which could eventually impact you.

7. Determine your appetite for risk. The key to doing this is building a model portfolio that defines your risk tolerance. What percentage of the bank’s capital should be exposed to what types of loans (as defined by line of business, geographic area, industry, type of property, etc.)?

Making exceptions to policy – for example, with respect to debt-to-income, loan-to-value (LTV) and the borrower’s credit/FICO scores – is, in effect, the acceptance of higher risk loans. This underscores the importance of carefully measuring risk on an ongoing basis, closely monitoring loans that increase your risk, and regularly reporting your findings to the bank’s board of directors.

8. Employ risk-based pricing. The problem wasn’t simply that banks took on excessive risk. Rather, it was that that they didn’t adequately price for it. This encouraged many lenders to take risks they might not ordinarily have considered.

For the first time in many years, community banks have pricing power, since most of the non-banks and alternative sources of credit that usurped that power in recent years have disappeared. The keys to pricing adequately for risk are: 1) devising a pricing model that defines exactly what each loan must earn in order to cover costs (including the cost of risk) and meet profit expectations, and 2) creating pricing agreements that communicate these expectations to borrowers.

9. Remember that cash is king. It’s an old clich√©, but it’s true today more than ever: There is no substitute for cash flow. Using current financial information, lenders should look at both the qualitative and quantitative elements of borrowers’ cash flow. What is truly driving cash flow? How stable and dependable is it? What effect will competition have on it? What are the cash flow trends, and how likely is it that they will continue? Not knowing the answers to these questions may set us up to return to an accumulation of excessive risk.

10. Establish expectations with borrowers. Clearly communicate to borrowers your expectations regarding their financial performance, the information that will be required to facilitate monitoring, and penalties that will be assessed for non-performance. Establish benchmarks that give you the ability to adjust pricing or call loans for non-performance, and don’t allow borrowers to repay interest with more debt or to increase their lending facilities arbitrarily.

Please contact our office to discuss these and other strategies in more detail.