Most bank pricing strategies are directly linked to a risk grade process and once you know how these work, it is reasonably easy to change behaviour to enhance your risk grade and reduce borrowing costs over time.
A banks risk grade process assesses each business customer and ranks them based on an expectation of the probability of the business defaulting on its loan, and if it defaults, the probability of the bank losing money.
Whilst no bank risk grade model is the same, the key ingredients are fairly predictable and can be broken up into 3 categories:
- Account Performance
- Financial Performance
- Customer and Industry Information
Account performance looks at the way businesses maintain their current bank relationships. Every time the business overdraws its cheque account or is late with a loan repayment, then a black mark is applied. Even new banks look for this as they invariably ask for bank statements from your current bank.
Risk grade models also frown on repeated requests for limit increases, and lack of adherence to scheduled principal reductions. Bad account performance is not only an indicator of solvency issues, but it is also an indicator of management integrity and ability in the eyes of the bank. If a business is not in the habit of adhering to its bank arrangements, then this might infer that management is not trustworthy. The bank would also be thinking that even if it doesn’t lose money from loan losses, chances are it will lose money from servicing costs as the extra management time required chasing late payments may make the customer too hard.
Financial Performance is based on the last 3 years financial information and uses performance trends and key ratios to test for high risk customers. Obviously businesses that are making losses, have negative cash or cannot demonstrate ability to meet interest and principal commitments will be penalised. However other indicators are less obvious; the fact that financials haven’t been prepared for more than 16 months after year end, measures of leverage indicating that the business is not too reliant on external funds (bank or otherwise), liquidity – ie the business has more current assets than it has current liabilities can all be detrimental influences on your risk grade.
Customer and Industry Information looks at the experience and competence of management. This includes whether management has allowed the business to go into debt with the Taxation office (an absolute no-no in the current banking market), longevity of the business and management in the industry, and the length of banking relationships.
There is also generally a risk factor applied based on the bank’s perception of overall industry in which the business operates. Certain industries will have negative risk influences, regardless of the performance of the specific business.
In most cases it is not possible to change a bank’s perception of risk at a point in time. The measures are quite objective and clear. However a business, armed with an understanding of where their risk grade is being adversely impacted, can plan to make changes that will rectify this above over time.