Q&A: Protecting Your Bank From Troubled Loans

With economic uncertainty persisting, banks are paying closer attention to early indicators of financial stress in their loan portfolios. Detecting these signs in time can mean the difference between an at-risk loan and a full recovery. We spoke with credit expert and seasoned RMA instructor Susan Bishop, of Clarity Credit Analysis, to discuss practical steps banks can take to stay ahead of potential loan troubles. In this conversation, she shares strategies for identifying early warning signs, engaging proactively with borrowers, and balancing data-driven insights with hands-on risk management. Interested in learning more? Enroll in one of RMA’s upcoming courses on detecting problem loans. 

How do you define a “troubled loan”? 

A troubled loan is one that the borrower is unable to pay back as agreed. There may be many reasons for this inability, and the key to managing the best possible outcome for the bank is to quickly identify the early warning signs and to get involved in managing the risk of loss as soon as possible.   

What are some of the most effective early warning signs that credit analysts and relationship managers should be watching for when monitoring a borrower’s financial health? 

The most visible early warning signs specific to the borrower include overdrafts, late payments, delinquencies, and not providing updated financial information. In addition, identifying industry and/or economic issues can alert the relationship manager and credit team to pay closer attention to borrowers in those categories.   

Warning signs that require financial reporting include covenant violations, declining or quickly growing revenue, increasing returns and allowances, compressed margins indicating increasing costs of labor, supplies or other costs to operate, slowing receivables, slowing payables, increasing accruals, movement of cash between borrower and guarantors or other related entities, and erosion of equity through losses or distributions to ownership.  

Once a potential issue is identified, what steps should bankers take to proactively engage with borrowers before the loan becomes classified as troubled, and how can they balance maintaining a positive relationship with protecting the bank’s interests? 

One of the first steps to take is a file and collateral review to determine if there is updated financial information needed and to identify any concerns around collateral value or liens. Updated third party reporting including credit reports, tax reporting and other data can be useful to determine if there has been increased borrowing by the borrower or guarantors, or liens or judgments filed. 

Communicating with the borrower’s management to determine what is driving the cash flow issues evidenced by overdrafts, etc., with a deep dive into operations and cash flow impacts. Has there been management turnover, fraud, litigation, bad debts, loss of suppliers or customers?   

Arrange a site visit, if possible, for firsthand observations including any deferred maintenance on the property or equipment, or environmental issues that might need to be addressed. 

In your experience, how can data-driven credit analysis enhance a bank’s ability to forecast loan performance and identify risks earlier? Are there specific tools or techniques you recommend that can aid in this process? 

Absolutely.  Aggregated data, when properly analyzed, can be predictive of losses in particular categories of lending, specific industries, and segments of the market. This data can alert the credit team and bank management to the potential for concern and direct targeted attention to the specific borrowers that may be affected. However, depending on the size of the bank and its resources, this data may or may not be accessible on a cost-effective basis. Peer analysis through data such as the RMA Statement Studies provides a broader look at the trends for a particular size company in a given industry.   

Given your experience working with institutions of all sizes, are there any notable differences in how community banks and larger national banks approach the identification and management of loans that could become troubled, and what can they learn from each other? 

Every bank has its own culture and way of assigning lending staff to borrowing relationships. In my experience, community banks tend to have relationship managers and credit teams that work with a wide variety of borrowers across many industries with diverse borrowing needs. Community bank RMs typically bring a borrower into the bank, working with them through various economic cycles and through a financial downturn as well.   

Larger bank relationship managers and credit teams tend to have greater specialization of industry experience or product delivery based on the borrower segment. Larger bank RMs may be more specialized as to the role played in bringing the borrower to the bank, managing and expanding the relationship, as well as managing the relationship through any financial downturns that may be experienced.   

What they have in common is the necessity to recognize industry and economic conditions, stay close to their borrowers, quickly identify declining financial condition, and/or the borrower’s ability to repay the loan, communicate within the bank and with the borrower, and work to protect the bank’s position in the event of a significant decline.    

While a relationship manager at any bank would need to be conscious of creating lender liability, there are many ways to proactively protect the bank against loss in a deteriorating situation.   

Many years ago, I was a relationship manager at a regional bank which was, for the first time, implementing a financial incentive program for RMs. The bank’s culture had always been one that rewarded RMs for identifying and communicating potentially problem loans as soon as they become apparent. The new incentive program included a financial disincentive to quickly communicate potentially problem loans. When this cultural shift was recognized, changes were made to the incentive program to more align with the bank’s culture.  

Recognizing how RMs are rewarded and recognized in every phase of the relationship with borrowers is a key to maintaining strong communication between levels of management. This level of communication can help to maintain a strong credit culture and protect the bank against potential loan losses.