RISKMANAGEMENT

Field Exams as a Cost-Effective Approach to Risk Mitigation

by Paul J. Schaefer he lengthy expansion in the U.S. economy has short-

ened memories, leading to more generous credit Tstandards and greater chances for problem loans. The author’s field exam department performed 79 initial exams for mid- dle-market companies over the past three years. Serious risks were uncovered in a number of exams—risks that had not been caught by either the lender or the underwriter. This article, based on a review of the results of those exams, demonstrates the cost-effective nature of using field exams to mitigate risk.

© 1999 by RMA. Schaefer is vice president and field examination manager for Bank One -Based Finance Group South/West in Dallas. In addition to performing field exams for the bank's Asset-Based Finance Group, Bank One's field exam department performs due diligence, ongoing examinations, and trouble-shooting examinations for the commercial middle market, syndications, large corporate, and capital markets areas.

62 The Journal of Lending & Credit Risk ManagementNovember 1999 Field Exams

ight years of an expanding and big firms to correctly Exam Results economy has resulted in provide information, don’t expect During the past three years, Ean overly competitive mar- the quality to improve with small- 79 initial exams were performed ketplace. Credit policies have er borrowers and smaller audit for middle-market companies. been rewritten beyond what once firms. The results of the exams were was considered essential for pru- Credit analysis is simple, if categorized into four groups with- dent lending. Profit margins have the lender has all the information. in prospect and existing cus- been trimmed thinner than was Therein lies the problem— tomers to indicate satisfactory or previously considered necessary obtaining the relevant informa- negative exam results. A capsula- to compensate for risk. Yet banks tion. One of the most underdevel- tion of the results is as follows: oped and underutilized tools for relentlessly compete to grow their Type Positive Negative Total portfolios, booking new loans middle-market credit analysis has Prospect 33 10 43 while exiting worn-out loans. been the field exam, long a main- Existing 23 13 36 stay of credit analysis in the asset- Often, the real difference Total 56 23 79 between new and worn-out loans based lending industry. In today’s is the lender's knowledge of the high-tech world, a personal com- The most important exam is the first, especially when performed borrower. As in the prior decade, puter and a laser jet printer are eventually a recession will come often all that is needed to provide on a prospect. Prospective and brutally shake out the weak a good-looking financial state- middle-market customers that rely heavily on borrowing bases lenders. ment. Behind the numbers, how- In early 1998, Waste ever, there sometimes lurks an are often approved subject to a Management reported a pretax unorthodox system field exam. Initial exams on exist- ing middle-market customers can charge of $3.54 billion dollars. that provides an uncertain picture The company had “used improp- of what is happening. To make be prompted by changing finan- er, overly aggressive accounting informed decisions, a lender must cial trends, line increase requests, or changing markets. While 71% tactics in an effort to boost sag- know whether a customer or ging earnings.”1 The misstate- prospect has adequate accounting of the exams were rated satisfacto- ments were so pervasive that it systems and management tools to ry, some exams pointed out nega- tive issues that were either miti- required the company to restate manage its business. Sometimes earnings back to 1992. Waste aggressive interpretation of the gated or were considered insignif- Management overstated its hard information by management and icant when compared with the balance of the report. However, 38%, which overstated their auditors can mask hidden prob- by 315%. A more recent lems; therefore, the lender needs 23 of the exams (29%) were con- example in April 1999 is FirstPlus an independent evaluation of the sidered to have one or more seri- ous risks. The largest issues Financial, which admitted “that information underlying the finan- investors shouldn’t rely on finan- cial statements. Lending is usual- uncovered were: cial reports it has issued since ly very forgiving. Many things can Exam Issues ProspectsExisting 1994.”2The financial shenanigans be done wrong without conse- Collateral problems 7 10 at Waste Management and quence; however, the more mis- Aggressive accounting 3 4 FirstPlus were no aberrations. takes, the greater the likelihood of Other accounting issues 2 7 Cedant, McKesson, Sunbeam, a write-off. Field exams can help Over inventoried 0 2 Livent, Rite Aid, Donnkenny, and mitigate these risks significantly. Delinquent payroll taxes 1 1 Commercial Financial Services Combining field exams with an Computer problems 1 0 also had high profile accounting adept monitoring of the cus- Ten (23%) of the exams on irregularities reported during the tomer’s monthly reporting can prospective customers found sig- past two years. When you cannot provide an early warning system nificant issues to the extent that rely on NYSE-listed companies for spotting negative trends. nine of them were declined credit

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facilities. Of the 10 prospects with advance in the most optimistic statement to the general to negative exams, six had approved circumstances. The problems with the detail. The importance of credit packages, three were given the asset quality included high audit trails cannot be overstated- term sheets, and one was given a dilution, weak customer base, and without them, financial state- commitment letter. Thirteen poor quality. ments become meaningless. (31%) of the existing customers Aggressive accountingis the When a company lacks the disci- were found to have significant overly liberal interpretation of pline to account for their business problems. Twelve of the 13 cus- assets to enhance earnings or col- transactions, they usually lack the tomers were over-advanced, based lateral and is often synonymous capacity to comprehend where on the recommended borrowing with misrepresentation or fraud. they are profitable and where base structures, two of which In the case of Waste Manage- they are losing money. exceeded $5 million. The over- ment, the company extended Surprisingly, poor audit trails do advances were created by a com- schedules and not necessarily preclude a compa- bination of aggressive interpreta- increased residual values of fixed ny from obtaining a certified tion of the borrowing base defini- assets. Examples of aggressive audit. It is important to note that tions and weak collateral. accounting at the local level what is not important to an audit Collateral problemsexist include recording dubious assets firm may be critical to a lender. when the recommended borrow- as trade receivables and fixed Another prevalent accounting ing base structure is insufficient to assets. Other tactics, such as bill- issue is accounts repay the loan. This can happen and-hold merchandise, can pro- that are not reconciled to the sub- when the existing advance rates duce phantom sales to increase . It is not unusual to have are aggressive and/or when ineli- receivables and flow. aggressive accounting combined gibles are understated. Recom- Receivables also have been with poor accounting records. In mended advance rates are often recorded when contracts were the fog of poor accounting, a cus- misconstrued to represent an signed even though the contract tomer can hide inaccurate or dis- absolute liquidation value; howev- was to be performed over the next honest information. er, there are too many scenarios year. Not only was the collateral that could affect the liquidation overstated, the customer did not Significance of the Study value of the collateral. The differ- record deferred or accrue Of the 43 prospect exams, 10 ence between forced liquidation associated , creating an were found to have substantial and orderly liquidation can be sig- overstatement of income and risks that had not been detected nificant. Recommended advance equity. Another customer with until the field exam. Without the rates are represented as reason- negative collateral issues had capi- benefit of a field examination, it is able when compared with similar talized a $2.2 million bad debt by probable that most of the companies in the industry or simi- purchasing its customer and show- prospects would have been lar relationships within the bank. ing the loss as . Though booked. The likelihood that one Determination of asset quality can the effect to the tangible net or more would have resulted in a be made from a thorough exami- worth was equal, the method of write-off is high, because, if nation. If the borrowing base dealing with the uncollectable booked, borrowing base structures structure of a problem situation is receivables allowed the company would have been inadequate to reasonable, the bank should be to maintain net profits and cash find an alternative lender or there able either to move the customer flow of $2 million higher than was would have been collateral short- to an alternative lender or to liqui- actually attained. falls in a liquidation. The field date collateral with minimal time Accounting issuestypically exam information allowed the and cost. The problem with the are associated with poor audit bank to pass on high-risk lending collateral of the above seven trails. The accounting records opportunities and to resolve those prospects is that it would not have should allow an examiner to track risk factors that could be mitigat- repaid the required initial cash the information from the financial ed.

64 The Journal of Lending & Credit Risk ManagementNovember 1999 Field Exams

For existing relationships, the exams furnished information that THEPOTENTIALSAVINGSINRELATIONTOCOST allowed the bank to better evalu- ISSIGNIFICANT ITHANAVERAGEREVOLVING ate the collateral values in the . W decision-making process. Of the COMMITMENTOF$5 MILLION, ITWOULDREQUIRE 13 negative results on existing customers, five were moved to ONLYAPARTIALSAVINGFROM ONERELATIONSHIP alternative lenders, two are per- TOREPAYALLTHECOSTS. forming satisfactory, two are being worked out, one was liquidated successfully, and three resulted in become blurred. All other things • Late financial statements write-offs; proving that early being equal, additional costs can should result in a loan being detection of a problem loan can be deleterious or even fatal to a downgraded each month until lower the write-off or increase the proposed or existing relationship. either a is produced or an exam is per- likelihood of it moving to an alter- Overcoming sticker shock. formed. native lender. Field exams should be free to all • Late borrowing base reports commercial lending departments are usually a strong indicator Allocating the Costs at banks that have a field exam that something is amiss. The study found that the cost staff. A management fee could be • Trending sales, receivable of an exam is very small in propor- allocated based on the size and agings, and inventory tion to the potential savings. The grade of the loan. If the lender turnover can be a cost-effec- 79 examinations cost $272,342, or then is able to collect any portion tive early indicator of collater- $3,447 per exam. The total pro- of the exam cost from the cus- al or financial deterioration. posed and existing commitments tomer/prospect, these monies • Only month-end borrowing on these companies was $530 mil- would enhance his or her profit bases should be used. Interim lion, of which $396 million repre- center. The additional exams will period borrowing bases seem sented revolving lines. An effec- lower the cost of the banks funds to have an inordinate amount tive cost of 0.069% was found for by reducing the expenses of availability when compared the revolving commitment, or incurred with classified loans and to month end borrowing $690 per $1 million. The cost in bad debts. This in turn will allow bases. Albeit, a company’s relation to potential savings is sig- the bank to be more competitive business cycle can distort the nificant. With an average revolv- in the market. ing commitment of $5 million, it value of a month end borrow- ing base. When a substantial would require only a partial saving Monitoring the Monthly portion of the sales are from one relationship to repay all Reporting invoiced just prior to month the costs. The weight of the Loans that depend on monthly end or if a substantial portion above information established borrowing bases should be diligent- of the collections are received that substantial savings did result ly monitored. When applied, they just following month end, the on more than one exam and that are defined standards that can average availability will be the savings reduced the funding serve as an early warning of a cus- overstated. cost of the bank. tomer in trouble even before the • The borrowing base needs to While the savings are obvious financial statements indicate a be reconciled to the compa- from a macro view, the value is problem. It is best to have a profes- ny’s financial statement; not always as clear on an individ- sional group monitoring the month- because reconciling an interim ual basis. Typically, the exam fees ly borrowing bases. Following are borrowing base is usually are collected from the customers some of the basic rules that can without a clear audit trail. The and prospects. However, in a com- help lenders to substantially reduce reconciliations can indicate petitive market, interest and fees the risk in monitoring:

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that the agings are overstated evident. Typically, it is necessary detectable by a diligent examiner. because of unapplied cash. to wade through these reports Misrepresentations of collateral by • The borrowing base should be several times to analyze the situa- an owner to deceive the lender kept simple. Complex borrow- tion. It is not unusual to spend are less frequent. It is not unusual ing bases are time-consuming, more than a day reading and to have customers embellish the often prepared incorrectly, and rereading the report. information sent in on a borrow- are easier to distort. ing base report. These exaggera- Is it fraud or shoddy exami- These procedures can be an early tions should be detected early and nations? The purpose of a field warning system for collateral and reacted to strongly by a lender. exam is to mitigate risk. The financial deterioration. There is no level of tolerance for a problem with many exam pro- dishonest customer and the rela- grams is that they are too mechan- Not All Exams Are Equal tionship should be exited imme- ical in nature. An inordinate Don’t assume “any old exam” diately. When minor misrepresen- amount of time is spent “filling in will do. Lenders buy and sell bil- tations are not caught, or tolerated the blanks,” leaving little time to lions in participations and syndi- when they are caught, then the adequately analyze the data. cations. The credit quality of probability of a “fraud” increases. During an industry function, a these transactions may be partially At that point, blaming a “fraud” field exam manager advised that a underwritten by a field examina- on a customer sounds better than customer had recently defrauded tion. There are no industry stan- admission of negligence. them. He said that the customer dards for a field exam. The scope had six- and eight-month terms ranges from one person and a few The Middle-Market Field from his vendors. The customer hours to several examiners for Examination was able to hide the payables several weeks. The exam can A middle-market field exami- from its CPAs and obtain annual range from a substantially narra- nation should be a process of ana- audited reports. The bank’s exam- tive format to mostly numeric lyzing a company’s books and iners also did not catch the under- presentation. Quality is not always records to better understand the stated payables. To the question, synonymous with quantity, and nature and quality of the assets, “How much money did you lend there is no single yardstick to tell liabilities, and cash flow. While on the payables?” his reply was, whether an exam is reliable. If the exam focuses on receivables, “None, the customer also had periodic examinations are being inventory, and quality of earnings, poor inventory records and the conducted when participating in a the process may include discus- inventory liquidated at substan- credit facility, it is beneficial to sions about the industry, changes tially less than the loan.” This was have one of the bank’s own exam- in the company, accounting sys- not a fraud; it was an inadequate iners participate in the exam. tems, and so forth. The examin- exam. Deficient accounting Lenders frequently receive er’s observations and conclusions records are a strong reason to field exams from the bank’s credit typically include recommended lower advance rates and probably approval area, underwriters, mar- advance rates for receivables and turn down a credit. Too often a keters, and others that have been inventory, borrowing base struc- “fraud” is declared to cover up an performed by other asset-based ture, management deficiencies, inadequate exam. lending groups, CPAs, and con- reporting requirements, and defi- Most frauds are perpetuated tract field examiners. The exam is ciencies in the monitoring. Field by a single employee against the accompanied with a request to exam time typically ranges from employer for personal gain. This decipher the essence of the five to 10 days. Some banks per- type of defalcation is difficult to report. When a bank’s knowledge- form abbreviated reviews that last catch either by the employer, the able financial people require an one or two days and call them auditors, or an examiner. When interpreter to understand a finan- field exams; however, these the fraud has a significant impact cial paper, then the need for a reviews are better classified as on the collateral, it should be clear, concise, terse report is very portfolio reviews or borrowing

66 The Journal of Lending & Credit Risk ManagementNovember 1999 Field Exams

base checks. and the workpaper exam. The has shortened memories and The field exam originated in middle-market exams tend to be made for more generous credit asset-based lending as a training more analytical and narrative, standards. The continued deterio- area for entry-level employees. while the asset-based lenders tend ration of standards will come Using questionnaires and workpa- to have more of a “fill-in-the- home during the next economic pers, the novice was sent to com- blank” workpaper format. The rea- contraction. While lenders will be panies to question the CFO and son is that in asset-based lending forced to pay for the relaxation of to copy information from the man- the examiner’s position is viewed credit standards, from a practical ual records. The completed exam as an information-gathering sys- standpoint, it is difficult to be a was returned to the office, where tem. The asset-based lenders and player in the market when the more experienced personnel—the credit people are thoroughly expe- competition lowers their credit lender and credit officer—ana- rienced in the examination process standards. The answer to this lyzed the information. With man- and can readily analyze the infor- dilemma is to better know and ual records and novices, this was a mation. In middle-market, the sig- understand the customer. A field cost-effective approach. nificance of the questions and exam can allow a bank to enter- In the late 1980s and early workpapers is not always clear. In tain prospects that otherwise may 1990s, the field exam hit an evolu- this area of lending, an experi- have been considered too risky tionary spurt as information pro- enced examiner is imperative. and avoid some that are riskier cessing went from columnar paper In designing an exam process, than they appear on the surface. to “totable” computers on wheels the lender must evaluate costs-ver- To a large extent, the serious to 15-pound portables to seven- sus-returns-versus-risks. The more risks found in the initial exams pound laptops. During this time, time spent at a customer’s location, mentioned in this article were not mainframe and personal computer the more likely the lender will detected by either the lender or prices were dropping and substan- wear out a welcome. Trivial the underwriter. The value of tially all accounting records became requests for information results in having an onsite analysis by an automated. The transformation was less in-depth information received. experienced examiner is very not entirely smooth. It was not It is important to balance concerns measurable. Risk management unusual to have a controller show and to develop a comprehensive, saves money, since one less loss an audit trail by pulling out a dupli- yet succinct report. Cost-effective- can fund the exam costs for many cate set of manual records that had ness will occasionally result in years. Just as additional high-risk been hidden in a lower desk draw- some missed information. The business can be added profitably er. During this time, the size and alternative is a bulky report that when prudently managed, the complexity of accounting records contains important information cost of additional precaution can grew exponentially, requiring buried within an abundance of be justified empirically. The field examiners with greater skills and trivial data that the readers must exam can be a cost-effective experience. While computers trans- waste time sorting out. The field approach to mitigate risk and formed the business world, not all exam report should be readable increase market share. Ë exam formats evolved. and comprehensible in less than an NOTES Workpapers are essentially the hour and contain a summary that 1 Elkind, Peter,”Garbage in garbage out,” same throughout the industry. The can be read in less than three min- Fortune, May 25, 1998, v137n10, p130-138 2“FirstPlus Financial may face delisting by stock workpapers used in an exam will utes. It should be user-friendly to a exchange,”Dallas Morning News, April 30, 1999, vary, depending on the information wide audience within the bank. Page 10D, available, perceived risk, and dic- tated requirements. The quality of Conclusions the information is largely defined Current credit standards in by the examiner’s skill. While banking have been driven by reports can vary greatly, there are short-term results. The long-term basically two formats: the narrative expansion in the U.S. economy

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