CORFU - a framework for credit underwriting

If you're in a credit team at a lender, you've probably heard of the 4 'C's of creditworthiness. You may even be sick about hearing about them. In today's post, we're going to look at an alternative way of remembering what's important in underwriting businesses: CORFU.

Let's start with the 4 'C's. Typically, these are Character, Capacity, Capital and Collateral. In short, passing all 4 would mean your borrower is likely to:

• intend to repay, urged on by their sense of obligation,

• have the ability to repay, having the financial means to do so,

• be motivated to repay, because the loan's purpose is of meaning to them,

• have an tolerable alternative to repayment, typically through the surrender of an asset of comparable value (the 'collateral').

While these seem reasonable at first glance, there are a few reasons why they aren't the best guide when lending to businesses in the modern world.

For starters, the 4 'C's are mainly oriented at consumer lending. This makes them ill suited to the peculiarities of lending to a business. They are overly moralistic, asking the underwriter to judge a person's character and motivations; this isn't all that effective when dealing with businesses. Finally, in practice they compress the majority of the work of underwriting into just one word- capacity. It would be nice to have a framework that recognises the many facets of capacity in a memorable way.

How can we improve on the 4 'C's then? I'd like to propose an alternative framework: CORFU.

CORFU stands for:

• Collateral

• Ownership and guarantees

• Reality

• Funding

• Unmet obligations

Let's look at each of these pillars more closely.

Collateral

This is the only one of the 4 'C's that is worth keeping, reflecting the essential nature of collateral in any lending arrangement. All lending involves risk, and by attaching collateral to the terms of a loan, the lender places a floor on their risk position; if the borrower is unable to repay the loan, they must instead surrender something of value (the 'collateral') which the lender can then resell to recover as much of the value of the unpaid debt as possible.

In the CORFU framework, it's important to ask these questions about collateral:

• How do I know the present value of the collateral is accurate, and will remain comparable to the value of the debt?

• Where is the collateral, should I need to inspect it in future or reclaim it?

• How liquid is the collateral, i.e. how quickly could I convert it into cash should I need to?

• How sensitive is the collateral, i.e. how much value does it lose either due to ageing, brand erosion or value loss during a period of general financial crisis?

• How can I ensure that the collateral has not been pledged elsewhere, so that I have sole or primary right to it?

• What are my rights to the collateral in the regulatory region in question? Is there anything in the law that would prevent me from reclaiming the collateral if the loan defaults?

Ownership and guarantees

When lending to consumers and individuals, it is possible to easily identify both the beneficiary and debtor for the loan funds. However, businesses can have complex ownership and control structures. Companies can own parts of one another, share directors, operate through trusts or provide guarantees to one another. Tracking this complexity accurately is a tough and necessary part of mitigating risk.

In the CORFU framework, it's important to ask these questions about ownership and guarantees:

• Who are the immediate and ultimate owners of the business to which I am lending?

• Who controls the business(es) in practice? It is important to identify if the people making decisions about the business differ significantly from those listed on the loan application, and hence accountable for the loan.

• Do any of the people or companies in this loan application appear in my existing portfolio? Having a single entity guarantee a significant part of a portfolio creates a lot of concentrated risk.

Reality

It is an obvious and vital step to ensure that the business being underwritten is real. Some common questions that arise are:

• Is the business registered with the government, regulators or certification bodies?

• Does the business transact with other recognised businesses, such as manufacturers or other lenders?

• Are the people listed as directors traceable?

• Do the locations the business claims to operate from seem legitimate? i.e. Are there verifiable places of business that the borrower is linked to?

Funding

This is the engine room of a good credit underwriting process. Determining the borrower's financial capacity is a key part of this pillar of CORFU. Equally important is determining why the borrower needs the loan and how they make use of the money they presently have access to. Common questions that arise are:

• What are the assets and liabilities of the borrower?

• What is their working capital position, i.e. are they flush with funds or operating on a very narrow window of working capital (which can lead to missed payments and eventually insolvency)?

• Why do they want a loan? If they are flush with cash, is it merely for tax or administrative reasons? If they are operating on narrow margins, is it to fund day-to day business, or for expansion?

• Besides the interest and fees they pay the lender, are there any reasons to fund the borrower? For example, will providing funding unlock the origination of future, more profitable business for the lender?

• What is the typical profit margin of the borrower? How does their annual profit compare to their gross and net asset positions?

• Is their revenue and cost base increasing or decreasing? Are they unusually volatile?

• When the borrower uses credit, how closely do they keep to the limits assigned? Are they systematically under the limits, right up against them, or constantly breaching them? Are there seasons or periods in which they need credit more than usual?

• Who are the borrower's typical suppliers and customers? How regular are their transactions, and would you be able to predict issues if these regular patterns change?

Unmet obligations

Future risk can sometimes be predicted by past behaviour, so it is important to identify problematic behaviour in the histories of both the borrower business, the people who control the borrower business and those who back them financially. Typical questions are:

• Has the borrower missed payments in the past, either with you or with another lender?

• Has the collateral used by the borrower on previous deals ever been called into question? Double-pledged collateral is a particular red flag, and systematically mis-valued collateral is also problematic.

• What is the history of the company directors? Have they worked in businesses that have failed or at which irregularities have been reported? Do they have financial or personal interests in competing firms, or political connections?

• Does the borrower business have a history of unmet obligations with others? Do they pay their suppliers on time? Do they pay their tax bill?

• Are there any CCJs, insolvency proceedings or legal cases pending at the borrower business, any of their directors or key decision makers, or amongst major shareholders or guarantors?

• Does the business, it's directors or it's key decision makers have a history of risky behaviour, such as substance abuse, gambling addictions, convictions for theft or violence or antisocial behaviour? Are they politically exposed? Do they have a large media or social media presence, and is it controversial or edgy?

Why use a new framework?

If we already have the 4 'C's to help us, why do we need another framework for credit underwriting? Well- the 4 'C's weren't built for business underwriting, and have struggled to stay relevant in the digital economy. While they're not wrong, they're not useful either. And that leaves room for a purpose-built framework for business lending.

Perhaps you have already embedded the 4 'C's into your training and culture, and are wondering how to accommodate another way of thinking about the credit underwriting process. How is CORFU better? CORFU is a series of directed questions, rather than 'buckets' into which borrower characteristics can be put. It's simpler and easier to memorise, and more relevant to the particular characteristics of business lending.

And, if nothing else, at least your team will be thinking of a sunny holiday destination while they use it!