What Small Businesses Really Need to Recover

Regulatory Roadblocks to a Recovery

Until the regulators ease their underwriting criteria for new and impaired loans, small business will not get access to credit.  If a lender grants a new loan to a business with marginal credit, the regulators will immediately call for the loan to be impaired.  This has the effect of making such loans unprofitable and simply not worth the aggravation for the banks.

Further, if an existing borrower is having difficulty and cannot make his contractual loan payment the banks are forced by the regulators to take action and liquidate collateral.  Instead of working with a borrower to restructure the repayment terms, the regulators are imposing harsh and arbitrary rules against lenders.  This behavior must stop or more small businesses will fail.

The issues at hand are:

  1. The credit evaluation used to approve a new loan and;
  2. Upon restructuring what amount, if any, should be recorded as an impairment.

1. Credit Evaluation:

It is nearly impossible for some small businesses to get credit.  Few institutions will approve a new credit applicant with weak personal credit and/or declining revenue and profits over the past two years.  If they did approve such a loan, the regulators would immediately cause it to be “classified” and trigger onerous and special handling of this new loan.   With all the troubles banks already have, why would they add to their issues with a less than perfect loan?  The answer is, they won’t and until the regulators ease up on lending practices, we will not see small business credit thaw.

2.  Restructured Loans:

The Financial Accounting Standards Board (“FASB”) Standards No. 114 “Accounting by Creditor for Impairment of a Loan, page 6 item 7 specifically states that, “This Statement does not specify how a creditor should identify loans that are to be evaluated for collectability. A creditor should apply its normal loan review procedures in making that judgment.” The OCC, which relies on FASB rules, tells financial institutions that the standard of review for a restructuring must be the same standard as for a new credit. This is clearly wrong because debt restructure candidates are by definition weak and would not pass credit approval using ordinary approval metrics. So right away, the lender is against the wall with respect to justifying why a restructuring was done. However, there is precedence for the OCC relaxing these requirements.

When hurricane Katrina hit the Gulf States the OCC released a service bulletin strong encouraging debt restructures and granting flexibility with respect to the defined parameters for a debt restructuring (http://www.occ.treas.gov/HurricaneQA.htm). This bulletin gave financial institutions clear instruction on how to do a restructuring and did not inflict harsh requirements or require rigorous reanalysis of the credit in order to grant the restructuring. I urge the OCC to again issue a bulletin offering similar flexibility given the economic hurricane that his hit the entire country.

Impairment Calculations

The OCC’s Bulletin on Troubled Debt Restructurings (TDRs) Topic 2: Loans, Staff Response to Question 1 states, “This modification of terms should be accounted for in accordance with Statements of Financial Accounting Standards Nos. 15, 114 and 119, which require that impairment be measured based on the present value of the expected future cash flows, discounted at the effective interest rate in the original loan agreement. (However, as a practical expedient, impairment may be measured at the loan’s observable market price, or the fair value of the collateral, if the loan is collateral dependent.) If the measure of the impaired loan is less than the recorded investment in the loan, the impairment is recognized through a valuation allowance.”

In a recent OCC exam, the examiners stated that they received instruction from Washington DC about how to calculate the impairment amount of a restructured debt.

Their instruction was NOT in accordance with FASB 114. Instead they held the institution to a higher and unreasonable standard. They required the bank to record a bad debt expense sufficient to bring the contract value down to a “well collateralized” value. In this economy, this too is an onerous requirement.  Even a portfolio of performing automobile loans would not pass this “well collateralized” test because of the drop in value of a new car once it is driven off the lot. The same principle applies in small business lending.  Once the equipment is delivered and installed it is no longer worth as much as when it was originally sold. Therefore, every contract that is reviewed and held to this “well collateralized” value standard will fail the test, and result in additional bad debt expense. This occurs even if the loan is current and not past due.  If the OCC examiners would adhere to the present value impairment test lenders across the country would be free to effectively restructure loan contracts without triggering an impairment charge.

In summary, the OCC needs to relax the credit underwriting requirements for new and troubled debt restructurings, as it did in the wake of hurricane Katrina. Secondly, they should adhere to the FASB 114 impairment test using the present value of the new (restructured) loan payments to calculate the amount of any impairment.  The enforcement of the above provisions will permit financial institutions to safely and reliably restructure commercial contracts without fear of repercussion from the regulators.

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avatar Posted by on Jul 29 2010 Filed under Economics, Featured. You can follow any responses to this entry through the RSS 2.0. You can leave a response or trackback to this entry

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