The New Underwriting: As Banks Evolve, So Must Borrowers

The New Underwriting: As Banks Evolve, So Must Borrowers

Bank lending cycles last about 7 to 10 years, and in every cycle bankers find some "out with the old, in with the new" approaches to lending. Sometimes that leads to a pivot in industry focus, such as a move in retail banking away from housing toward autos, and in commercial lending from commodities toward healthcare.

Sometimes this leads to differences in how underwriting is done, which is applied across industries. During the last economic rodeo that ended in 2008, both retail and commercial lenders became enamored with "low documentation" loans. Essentially, they were betting that higher loan volumes at lower underwriting costs would balance an expected rise in underperforming loans. That didn't end well. After the predictable decline and then slow rise in lending after 2009, lenders searched for the next "new" approach to loan underwriting.

As the economic recovery progressed, banks came under greater pressure to grow earnings, which meant closing more loans. As one would expect, in the first few years of economic recovery banks began dipping their credit risk toe back into business lending at the low end of the risk spectrum. In franchising, that meant multi-unit operators, and banks were stumbling over one other to offer them better terms. However, there wasn't enough loan volume of this type to go around, so some banks started moving up the loan risk curve. SBA lending, because of its guarantee structure, became a darling of banks and volumes spiked. Now we are seeing the "new normal" phase of commercial lending, with loan structuring and pricing becoming key differentiators as banks move further out on the risk curve.

All these trends are predictable behaviors during an economic recovery. Lenders learn from what didn't work well during the last downturn and make changes to how they underwrite. Before I explain what bankers learned from the last cycle that is changing franchise lending, I should mention two other trends that are affecting where we are today.

The first is regulation. When an economic downturn is caused by a financial crisis, as the 2008 recession was, you can count on regulators to react strongly. And, right on cue, we saw a litany of new banking regulations. Two key results were much greater documentation requirements for commercial loans and greater bank portfolio stress testing requirements to determine capital reserve adequacy. Both of these had implications for franchise lending.

The second trend is technology. With the onset of "big data" risk analysis and easier access to more sources of information about an industry, a brand, and a borrower, lenders began experimenting with new ways to approach commercial loan underwriting.

What does all this mean for franchising? The answer is a lot--with more coming. To grow, franchising must have continuing downstream access to capital. It's a basic tenet of the business model. Adapting to the changes that banks are starting to introduce is necessary to see a continued flow of capital.

How underwriting is changing

Loan underwriting essentially is an activity that tries to understand the past to predict the future. This means looking at a borrower's historical business and personal results, including financial statements, tax returns, and business and personal behavior, often in the form of FICO scores and personal interviews. What lenders learned from the last lending cycle is that franchise lending has two attributes that help banks improve loan predictability: uniformity and conformity.

If the same potential borrower is considering two franchise brands, the underwriter should be able to predict which brand has a higher likelihood of a successful franchisee and therefore a performing loan. Doing so requires better brand underwriting due diligence. Technology, especially in this era of "big data," gives underwriters more access to information. The challenge they have is putting that information into an underwriting model that predicts loan outcomes. This need is being accentuated as regulators put more pressure on them to defend their underwriting due diligence and stress test their loan portfolios for capital adequacy.

Banks asked us whether a scoring model akin to a borrower's FICO score could be developed to put franchise system credit risk into a relative performance context. Over the past two years we have developed and refined a model that is doing just that: FUND Scores and their associated FUND Reports. The model looks at 13 factors that influence franchise system credit risk from a lender perspective. It is built on a 950-point model and looks at a minimum of 5 years of franchise unit, system, and franchisor history. Banks can purchase a report, and franchisors can obtain a report and consultation as a component of the financing eligibility services FRANdata offers.

The 2008 recession and frustratingly slow recovery has been difficult to experience. At least one good thing came from it: Lenders now have an objective and rational basis to reward better performing brands with more and less-expensive capital, and "reward" underperforming brands with less and more-expensive capital. For years franchisors have been told their franchise system performance matters. Now it matters to lenders.

Darrell Johnson is CEO of FRANdata, an independent research company supplying information and analysis for the franchising sector since 1989. He can be reached at 703-740-4700 or djohnson@frandata.com.

Published: November 3rd, 2016

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