Advanced Credit Underwriting: Determining Borrower Interest Rate Sensitivity

Underwriting borrower interest sensitivity

We monitor many banking schools and credit training programs and it is rare that we see anyone teach the analysis of a borrower’s interest rate risk position. For that matter, in hundreds of credit reviews that we see a year from a variety of banks, there is rarely a quantification of how rising or falling rates will impact credit risk. Given that the industry is still near all times lows, a position we have never been in before, borrower interest rate sensitivity, and hence their sensitivity to inflation, will play a major part of credit in a quickly rising rate environment.  Here is an overview of what every lender should know as it pertains to understanding the asset-liability position of a project or business.


Leverage: The first element of understanding a borrower’s sensitivity to interest rates is their mix of debt and equity in their capital structure. The more stable the revenue stream, the greater their capacity for debt and the lower their cost of capital. A start-up or highly volatile business will likely be financed with almost 100% equity. A more mature business with contractual revenue streams, the opposite.


The reality is that most businesses need a mixture of both debt and equity and the amount of debt employed, or leverage, is one major factor in interest rate sensitivity. The greater the interest cost volatility, the possibility for more risk. This is why asset-liability management is so prominent for a bank with its eight or ten times leverage.


Once leverage is determined, understanding the structure of interest rate resets or sensitivity on the entire debt portion of the capital structure is central to strong credit underwriting. Looking at the average duration of the total combined borrower debt is a number we rarely see in credit analysis, but is so important to getting a handle on borrower interest rate risk. If the borrower’s debt is all floating, the duration will be short which could spell heightened interest rate sensitivity in a rising rate environment and better debt service coverage in a falling rate environment.


Whatever the number, bankers should ask enough questions and conduct enough analysis to determine the amount of global leverage and how the debt resets, best quantified with duration.


Revenue volatility:  Once you have a leverage ratio and a debt duration the next question to ask – can the borrower handle the risk? Here, an analysis of the cash flow stream is the core of this analysis. The more sensitive the revenue stream in movement in inflation and interest rates, the greater the capacity to handle short duration or a floating rate debt structure without suffering increased credit risk.


One important question to ask to business principals is how often do they change product prices? Having an understanding of product price volatility determines how much revenue could go up or down. Hospitality is very sensitive, while non-commoditized products, such as products with intellectually protected technology might be sensitive to rising rates, but not for falling rates.

Next to product pricing, contractual pricing is the next question bank underwriters need to explore.  Sometimes product pricing is sensitive to interest rates but industry convention in the contract is to never reset pricing. Here, contract term matters. Whatever the case, inquiring as to inflation or price increases in the borrower’s contracts is an important aspect of understanding borrower interest rate risk.


For commercial real estate, the process is much easier than with a service or manufacturing company. For real estate, credit underwriters merely have to look at the lease terms and see when rent and cost increases come into play. Oftentimes, adjustments for inflation occur annually which means there is about an eight to eighteen month lag between when inflation occurs, when it gets reported and when the contract adjusts. Understanding this lag is important, as just because a lease or rent contract has adjustments for inflation every year, if it is based off the annual consumer price index for the previous year as published in the Wall Street Journal, then it could be eighteen months before inflation in the economy makes its way into higher rents.


Finally, for commercial real estate, banks need to understand the weighted reset period for inflation (both rents and costs) of all lease obligations. By looking at the size of each lease and then weighting the rest period, banks can now understand the duration, or sensitivity, of the revenue stream.


The bottom line is that in this environment, bankers need to take the time to understand the asset-liability position of their borrower. For banks looking to manage their borrower interest rate risk, we have the ARC Program that converts fixed to floating rates so that your borrower can have a fixed rate obligation while your bank enjoys a floating rate payment stream. For certain borrowers, this is ideal. 


We are standing by to help in the analysis, but the reality is that every borrower is different and each has a different capacity to handle rising interest rates. The key for banks is to not to get caught off guard and quantify this risk during the underwriting process. This will not only give your bank a competitive advantage in credit risk management, but will also add significant value in educating your borrower. 

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