The Borrowing Entity
Category: Financial Risk Management
Who is the debtor?
This may seem an obvious, and perhaps irrelevant question, but the lending banker must be fully aware of the person or entity to which he is providing credit, and who, or what entity, will have a legal obligation to repay the loan.
For instance, a business customer might be any of the following:
— Sole Trader
— Partnership
— Limited Company
— Unlimited Company
We do not have time here to go into all of the legal distinctions between these borrowers, and indeed these will differ from country to country, but obviously the lending banker must have a clear understanding of who is the debtor and to whom does the Bank have legal recourse. This will not only affect the completion of loan documentation, including security, but also the level of risk attaching to the loan. For instance, lending to a sole trader where the Bank has ultimate recourse to all of the private and business assets of the individual may carry much less risk than lending to a limited company which has been set up with very little capital and has very small net assets.
What might change?
We have already considered how quickly the modern business environment can change. This also applies to the ownership or management of a company. Ask the trainees to give an opinion as to whether credit risk increases or decreases in the following scenarios:
A sole trader forms a limited company and asks for all borrowings to be transferred to the company.
A family business is taken over by a much larger company, perhaps a multinational holding company.
The founder of a successful firm dies and control passes to his sons/daughters/nephews/nieces.
One partner is bought out by the remaining partner(s).
There are several similar scenarios we could illustrate. There is no one right answer with regard to the effect on credit risk of change in ownership etc. The lender or credit analyst must be aware of the possibility of such changes and must be in a position to judge the effect on the safety of the Bank’s lending.
Summary
In this session we have seen that, in addition to a detailed study of the financial position and prospects for a borrower, the prudent lending banker must also give considerable attention to having proper and sufficient security and, also, to structuring the debt properly.
In the final session, we will consider the need to have balance in a bank’s debt portfolio, we will summarise the framework for credit risk analysis we have built up in this training module and the previous one in the series, and will have a look at a comprehensive case study to see if we can put this framework into action