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The bank with a sound, written policy should be able to build a prudent, profitable contractor portfolio. This article offers a generic policy that readers can tailor to their individual bank's credit culture and season to their own risk appetite. The form and content of this policy represent a composite of many banks' contractor policies shared with the author by bankers who have attended RMA's "Analyzing Construction Contractors" workshop over the past 15 years. The author invites readers to, "Sharpen your pencils, hold on to your erasers, and as you edit the contractor credit policy presented here, follow the 1773 advice of a college tutor quoted by English writer Samuel Johnson: Read over your compositions, and where ever you meet a passage which you think is particularly fine, strike it out."
During their careers, bankers lend to borrowers, good and bad, eventually to learn through experience which is which. William Saroyan observed that good people are good because they've come to wisdom through failure. By that measure there are many good people in construction as well as in banking. Commercial bankers find lending to contractors challenging because of their vulnerability to the economic business cycle, low entry barriers, price competition, and industry volatility.
* Construction activity oscillates far more than the undulating business cycle that drives it.
* Entry into many construction lines of business has no formidable barriers other than regulatory licensing and the capital investment required for the heavier construction trades. Easy entry draws many into the construction business who have neither the financial strength nor the management acumen to survive.
* The ability of the many competing contractors to differentiate themselves is limited; the problem is exacerbated by bidding for work on price.
* Low gross profit margins leave little funds to cover variable interest and tax expenses.
Given these problems, it is more the wonder that bankers would risk lending to contractors at all. Still, banks prosper as communities grow, and the growth requires physical infrastructure to sustain economic expansion. Someone has to build the homes and offices, lay the roads and water lines, and wire the electric and cable utilities. Contractors contribute much to the local economy, and banks that lend prudently to creditworthy contractors help themselves and their community.
With an effective policy, banks can lend successfully to contractors. To that end, an example is offered in this article that banks can tailor to their own needs. For example, every bank has its own distinctive credit culture and its own unique way of expressing its credit policies. Some banks prefer guidelines to policies and show their tolerance by a preference for "should" over "shall." Other banks view their policies as educational and include insights, tips, or explanations for the policy in question. The bank that prefers brief guidelines will write a shorter policy than the bank that wants specific, complete policies. Regardless, it usually is easier to edit down a more comprehensive policy than to enlarge a brief one. The generic policy presented on the following pages is long enough for most lenders to edit it more liberally or more conservatively as appropriate.
Credit Policy for Contractors
Portfolio Risk Management
High risk. The contracting business is riskier than other lines of business. Problems lurk in:
* Its high sensitivity to business cycles.
* Intense competition due to relative ease of entry into many of the construction trades.
* Low profit margins caused by the competitive bid process.
* The high probability of work stoppage caused by inclement weather or other work flow interruptions.
* The limited supply of management experience in field construction, marketing, finance, logistics, and other facets necessary to success in construction.
Contractors fail more frequently than those in other lines of business, and the failure rates rise faster during recession. The statistical record of contractor failure validates its classification as a high risk industry.
Authorities. Because of its high risk, only lenders judged to possess the appropriate experience and skills are authorized to extend credit to contractors. Construction lending authority will be granted to such qualified lenders by the appropriate executive management. Construction lending authority is required to extend any credit to companies defined as contractors in the following paragraphs. Further, contractor requests with policy exceptions will require the concurrence of credit policy officers authorized to concur on contractor requests.
Policy exceptions. Certain red flags in lending to contractors have been identified as policy exceptions. A credit request with one or more policy exceptions …