In banking, as everywhere else in life, you never get a second chance to make a first impression. The first page of a credit memo is essential for credit analysts, lenders, management, and board members. The first page is prime real estate where the average reader will spend 25% to 50% of the time reviewing the credit submission. Because the first page commands so much of the average reader’s time, it is vital to draft the first page clearly, concisely and compellingly.
The Credit Memo
We review hundreds of credit memos every month from a wide variety of community banks across the country. We see memos from banks ranging in asset size from $50mm to over $10B and loans ranging from $250k up to over $50mm. We look at memos for annual reviews, and submission for new CRE and C&I loans. The average credit memo is about 8 to 10 pages and ranges from two pages to about 75 pages.
The first page of the credit memo is essential not only because a readers spend the majority of their time on the first page, but because many senior managers and board members will only read the first page and only skim or reference other pages in the memo. While many banks use pre-formatted software, there is ample opportunity to make the first page of the memo more effective whether your bank is using a software package or a word processor application.
Crucial Contents of the First Page
The credit memo’s prime purpose is objective persuasion; to do that the memo must outline the risks of the credit and the mitigating factors to those risks. A credit memo is an opportunity for a lender to be an advocate for the borrower, and the first page will achieve 25 to 50% of that advocacy. The first page should always have the same format at your bank. Board members and bank executives have little time to review the credit memo, and maintaining a uniform format makes it easy to find information quickly.
The first page of the credit memo should be a summary of the objective persuasion and should contain the following four sections:
Purpose of the request: Here the reader is informed why they are being asked to spend two to thirty minutes of their time reviewing the submission. A new unsecured, leverage credit, for $25 million will command a different amount of time and resources than an annual review. We see multiple examples of credit memos where we need to flip pages to understand the request. The first order of business is to establish why and how the reader is spending time reading the memo.
Borrower and Loan Information: This section will outline the borrower(s), guarantor(s), loan amount, structure, and pricing. Usually, in a table format the following information is included:
- Loan amount
- Amortization period,
- Commitment term,
- Type of facility,
- Business type and cash-generating sources, and
- Form of collateral.
This may sound like a substantial amount of information, but in a table format it takes up less than a quarter of a page for each facility.
Profitability and return: We recognize that not all banks measure risk-adjusted return on capital (RAROC), but most banks do want to understand the profitability of the credit and relationship. For example, how likely would a board member read, much less approve, a negative ROE credit? But in fact, a good percentage of credits have marginal return, because of credit risk, small loan size, short expected life, or lack of cross-selling and upsell opportunities. If your bank does not measure risk-adjusted return on capital (RAROC), at least quantify the lifetime expected margin of the credit – the result will be that board members will apportion their time to credits that have higher revenue impact to the bank. We estimate that the average commercial credit at a community bank produces just $6k in lifetime gross revenue – not worth most board members’ and senior managers’ time.
The credit summary: Most banks include the credit grade for the loan, but this section should also show project and global cash flow summaries such as debt service coverage ratio (DSCR), leverage ratio, and debt yield. This section will also show collateral coverage and guarantor strength. If a bank can calculate the probability of default, loss-given-default, and expected loss, all the better and these numbers should be included in this section. It is vital to show project-level cash flow because the most significant determinant of default is not global but project level repayment capacity. If the project does not cash flow, the equity is gone, and guarantors are motivated to protect their own assets, not the creditor’s assets.
Good credit people will always want to know the three biggest risks identified in the credit. We feel that risks and mitigants do not belong on the first page. Every good credit memo will have the top three risks and mitigants. The professional credit managers will flip to that section for every review, but the first page need not include this information.
Out of a finite amount of time to draft a credit memo, the first page demands the most time and attention. The first page sets the tone, contains more than 50% of the germane information to make a credit decision, and many busy professional bankers and board members spend the majority of their time reviewing the first page only. With a little planning and structure of the first page of the credit memo, every lender can become a better advocate.
Submitted by Chris Nichols on September 12, 2019