How Community Banks Use Non-financial Signs To Signal Credit Problems

Early Detection of Credit Losses

Community banks have a distinct competitive advantage in identifying problem loans. While many bankers are taught to identify financial factors that portend problem credits, evidence suggests that for smaller commercial credits it is non-financial indicators that are better predictors of credit deterioration. Because community banks have close ties to the sponsors and individual obligors, community banks are better suited to identify problem loans, correct the problem, and minimize credit losses. In this article, we serve up a training reminder to help lenders, business development officers, and credit administrators to be on the lookout for non-financial signs of stress.

Non-financial versus Financial Indicators

Most bankers (especially those that have done a stint in special asset management) are well versed in looking for financial red flags.  We have been taught to pay attention to cash flow, liquidity position draws on revolvers and other important financial ratios.  Unfortunately, this analysis is not always effective for the following reasons:

Time Lag: Financial statements are produced periodically and present historical positions.  Most community bank borrowers produce statements annually and the financial statements are disclosed up to 9 months after the reporting period. Therefore, bankers are often reviewing a borrowing entity’s financial position up to 21 months in arrears.  Over that period the borrower may deteriorate substantially without giving the lender an opportunity to respond.

Bias: Financial statements are management’s reflection of the performance of the reporting entity.  Management has much latitude in presenting the information according to GAAP (if in fact, the borrower is following GAAP).  While the accounting fraud found in the Enron scandal was extreme, every balance sheet, P&L and cash flow statement are reflections of what management wants to disclose.  There are many acceptable GAAP entries that can hide or do not fully disclose financial realities.

Lack of a global cash flow view: Many banks do not receive sufficient global financial information from their borrowers.  While the specific borrowing entity may appear healthy, many bank clients have multiple entities and not understanding the holistic financial picture puts credit departments at a significant disadvantage.  Playing “shell games” has historically been a popular hobby for borrowers during difficult economic times.

Non-Financial Indicators

In contrast to financial indicators of borrower deterioration, non-financial indicators are much more difficult for borrowers to hide or to cover.  These indicators tend to be real-time events that give bankers immediate information.  Understanding what to look for is important, but having access to this information is paramount.  Community bank lenders and managers have contact with borrowers in their community and are readily able to identify, interpret and then respond to these non-financial indicators.

Some of the most important non-financial indicators are as follows:

  1. Family or marital problems are one of the biggest distractors for borrowers.  With small “key-person” obligors, distracting the important decision maker can cause financial ruin.
  2. Employee relations is a key indicator of borrower stress.  Certain employees know more about the company than anyone with only access to financial statements.  Employees are the canary in the coal mine when it comes to borrower performance.  Bankers should immediately recognize the red flags when competent employees leave the company or express dissatisfaction with management.
  3. Customer relations is also a key predictor of borrower performance.  When customers start to complain about performance, service, or attention, then the borrower’s financial deterioration cannot be far behind.
  4. Major changes in the lifestyle of the owner may be a harbinger of the borrower’s financial conditions.  Borrowers that sell their vacation home, or do not renew club memberships may be trying to preserve cash.  Community bankers should be paying attention to how borrowers are allocating their resources outside of their business.
  5. Evasive borrowers and managers may be trying to hide problems.  Bankers that are no longer getting access to their clients or clients that report critical missing documents are cause for concern.
  6. Change in professional vendors should also be keenly observed.  Borrowers that change accounting firms or law firms are sometimes trying hide problems from their auditors or lawyers.
  7. Increased inquiries from other creditors are also a possible sign of financial concerns with the borrower.
  8. Transactions that are done at prices other than market such as a sale of assets can be a sign of problems.
  9. Weak internal control environment such as the lack of segregation of critical duties, inexperienced oversight or little monitoring increase the probability of fraud.
  10. Lastly, judgments and liens on the borrower should raise red flags with bankers.


Having an early warning system is very important for banks. Experienced lenders should be well versed to look for these early warning signs and proactively inquire to verify that these signals are not present.  The ability to identify borrower problems as early as possible gives banks the opportunity to intervene, counsel the borrower, shore up collateral, correct documentation issues, and guard against further exposure.  All this leads to lower credit loss and better bank performance, and typically less loss for the borrower as well.


While most banks are focused on financial indicators of credit deterioration, it is the non-financial indicators that are better signs credit deterioration.  Non-financial indicators are typically real-time events, more difficult for the borrower to hide, and can lead to a much earlier identification of problems than financial indicators can.  Community banks with their close borrower relationships have a competitive advantage in being able to identify non-financial events and respond to them accordingly.