Early Warning Indicators: What a Lender Watches For

The formal triggers in a loan arrive late. A financial covenant is tested at set dates, quarterly, half-yearly or only once a year in many mid-market facilities, on accounts that take weeks to prepare. Arrears come when the cash has already run out. By the time either fires, the owners have fewer choices, suppliers may be unpaid and the security may be worth less than it was. A bank that learns six months earlier can still talk about equity, stock or a sale while those options are open.

In Australia, early identification is a prudential requirement: APRA's credit risk standard obliges authorised deposit-taking institutions to keep prudent, documented policies for identifying and managing problem exposures early. Banks in New Zealand and the UK run comparable monitoring inside their own credit risk frameworks. Expected credit loss accounting, which banks apply under IFRS 9 and its New Zealand and Australian equivalents, adds a further reason, because a loan whose risk has risen significantly since it was made needs a larger provision, and the bank has to notice the rise to book it.

The signals come from four places. The account itself, which the bank sees every day: a line that sits near its limit for months, a rising floor below which the balance stops falling, limit excesses, payments returned unpaid, falling credits through the account, transfers between group accounts that grow larger and rounder. The borrower's reporting: monthly or annual accounts that arrive late or with a qualified audit opinion, covenant headroom that narrows from test to test, debtors that take longer to collect. The outside world: trade-credit bureau reports of slow payment, court claims, the failure of a large customer. And the relationship: a finance director who leaves, an auditor replaced mid-engagement, owners who stop returning calls, a limit increase wanted by Friday.

Many banks score the account signals automatically, weighting each by how often it has come before default in their own book, and open a review when the combined score passes a line they set. Signals that need judgement, such as a resignation, are entered by the relationship manager. The weights and the line differ from bank to bank. Two features matter more than any single weight: persistence, since one excess in a busy December says little and one every month says a great deal, and combination, since signals from separate sources rarely agree by accident.

A tyre and wheel distributor, constructed for this page, has a US$3m overdraft and a US$5m term loan, with a debt service covenant tested quarterly. Its bank weights signals as below and opens a review at a score of 5. The weights and the line are the example's, not a market standard.

The review opened four months before the covenant test, and no one signal opened it. February alone could have been a shift in the season; March alone, a stock purchase. By May the signals had come from the account, from the reporting and from the bank's own excess report, and they agreed.

The review did what the score could not, which was to ask why. The distributor had lost its largest fleet customer in January and was carrying stock bought for that contract. The credit officer asked for a 13-week cash flow, an aged stock list and weekly debtor reporting. By the time the returned debits put the file on the watch list in July, the owners had agreed to sell US$1.2m of surplus stock to another distributor at a discount and to put US$500,000 into the company. When the covenant broke in September, the waiver came with conditions already agreed rather than at the start of a first difficult conversation.

A covenant is a term of the contract, and a breach gives the bank rights: to call a default, charge a waiver fee or reset the terms. An early warning indicator gives the bank no rights at all. It is the bank's own reading, and the borrower may not know it has fired. So the bank acts on it by asking questions, reviewing the risk grade and preparing, not by demanding repayment. Arrears sit at the other end of the scale. They confirm what the signals suggested, and at 90 days past due on a material amount they count as default under the capital rules.

The indicators also feed other judgements without deciding them. A file under review may be downgraded, and the movement shows up across the book as rating migration. Its watch-list status is commonly one of the inputs a bank uses in deciding whether the loan's credit risk has risen significantly for accounting purposes. And a serious combination may lead a credit officer to the separate question of unlikeliness to pay.

DEFINED IN ONE PARAGRAPH → · THE WATCH LIST → · HOW BANKS MANAGE CREDIT RISK →

Lead time is bought in the facility letter. The monthly accounts, debtor reports and compliance certificates that a lender requires are the raw material of half the signals, and a bank that waives monthly reporting for a comfortable customer gives up months of warning in exchange for goodwill. At the annual review, the year's record of excesses and late reports is read beside the financial statements.

The borrower's own conduct changes the reading too. The same lost customer, reported by the owner in a phone call in January, reads as candour, and the bank's response starts from trust. Discovered by a scoring model in May, it reads as something kept back. That is the reading behind Issue 09, The Tuesday List, where a portfolio review has room for two files and the late reports and changed advisers matter more than the weakest ratio.

ISSUE 09 · THE TUESDAY LIST → · WHAT TO SEND YOUR BANK EACH MONTH → · THE THREE MODES OF WATCHING →