The 5 C's of Credit are Character, Capacity, Capital, Collateral, and Conditions. They are critical factors that lenders use to assess a borrower's creditworthiness.
These factors help a bank evaluate the risk involved in lending to a particular borrower. They can determine if a borrower is likely to repay the loan, the financial capacity to do so, the assets available to secure the loan, and the economic conditions that could affect repayment.
Yes, while economic conditions may change, the 5 C's of Credit remain crucial tools for assessing credit risk. They help lenders navigate uncertain economic times by providing a holistic view of a borrower's ability and willingness to repay a loan.
By understanding these principles, borrowers can better position themselves to secure loans. They can work on improving their creditworthiness in these areas, increasing their chances of loan approval and possibly obtaining better interest rates.
Mitch Woods: Welcome to another episode of Lending Made Easy. Today we're diving into an interesting topic, the relevance of the five C's of credit and today's changing economic landscape. And I'm joined by two guys with the character and capacity to unravel the mysteries of today's economic landscape, David Catalano and Bryan Peckinpaugh
So with the, with the rise of FinTech shifts in consumer behavior, there's. kind of a debate whether or not the traditional credit evaluation standards really still hold up. So, so David, I'll kick it off to you first. So the question to start us off, do the five C's of credit, so character, capacity, capital, collateral, conditions, do all of those still matter in this time where we're seeing such a rapid financial transformation?
David Catalano: Yes.
Mitch Woods: the end of the episode?
David Catalano: Well, so, so let's, let's just pick these apart a little bit. Character is really around your credit history and that's just a, a record of how you behaved in relationships you've had with other people like me. Right? So I'm a bank. How have you behaved with other people like me historically? That's it. That's a key that's, that, that works for anything, not just lending money, doing a business deal, going on a trip together. You want to go to Europe with somebody with when you had their, you had their going to Europe, report, you can look at how they behave with other people when they went to Europe with them. That can help you decide, do I want to go to Europe with this person? So it's just a way in which you can, help other people understand how you are going to behave in that, in that contract you have with them. So it's a wonderful thing. And I can't imagine that not working. across the board for a very, very long time.
And then if you look at the income, do you actually have the money to pay me back? I mean, how much more basic could that be? So I don't think that's going to go away at all. And you don't always have to have collateral because sometimes the collateral is either not worth it or it really depends on the type of loan but if you think about a credit card loan or a home equity loan where you're in second place, Collateral is, is important, but that capacity and that, and that character are so key. They're just so important. And then, the conditions really around what, what's the, what's the use of the proceeds.
So are you going to borrow money to go trade the futures market? it probably wouldn't matter what your, what your character and your debt to income is. It's probably not a good idea. So that might be a use for declining that loan. But I don't, I think these are timeless. I just, I just don't think that they're really, If you think about it, that's human behavior and you're, you're really modeling human behavior and trying to decide how to, how should I, should I be involved with this person or this company?
And typically the company follows the person, especially in a smaller company. And I think that's just a timeless, it's like a chart pattern for a stock. I mean, those, they, they show the same patterns over and over and over. You can look at a chart pattern from 1910 and look at a chart pattern from yesterday and they, you can see similar characteristics and it's just the humans behaving. So yeah, I think these are all, these all still work.
Bryan Peckinpaugh: Yeah, you nailed it, David. It's timeless. It really and truly is. And I talk about it outside of even just this world of credit. That now, more than ever, is the time to return to the core principles and foundations of banking. we, we've seen some of the challenges that the large regional banks have seen, some of the largest bank failures in history in the last, nine months.
We, we see the demand for core deposits and capital ratios that, that everybody's focused on. These are all core tenants of why banks existed from the very beginning and how they could grow as solid businesses in and of themselves and the five C's of credit are no different. Now that said. What I do think is interesting to talk about and where I think some of the, the scuttlebutt in the, the news and the trade rags, Mitch, back to your point of, are the five C's of credit still relevant? What does change in different economic times across different institutions is how you weight the differences. So, if we were to rewind to some of the boom times of our economy, character can trump all, especially if you go back, call it the 50s, the 60s, that, that type of era where deals got done on handshakes of, look, I know this guy, I know his family, I know everything. Even if he loses his house, he's going to pay off this loan. That's all character, right? And that would have trumped some of the other C's that might not be there for that particular borrower. So I think it is important to look at what may be more relevant than others. What types of trends are we seeing in the behaviors of our financial institutions?
Because not all of these are weighted equally at any given point in time. I think. The conversations that I have been a part of lately, character has become less of a weighted factor, that there's a lot more interest put on capacity in particular, lots of focus right now on ability to repay, whereas that was a heavy, heavy factor in small business as an example, starting to see that creep even more into commercial.
What, what happens if this goes bad? What are my recourses? Collateral thus is much more important maybe than it has been in the past. What can I get out of what is put up to secure this? David, I don't know what are you seeing conversations you're having? Are there one or two of the C's that do you think might be more important than another right now?
David Catalano: I still think the character is always important.
Bryan Peckinpaugh: Oh, no, not arguing that. It's not just that maybe lesser of importance today, you could be high character with no capacity to repay. You're not going to get the loan.
David Catalano: Yeah. And I, I do, I do see because of certain asset classes are, are in question today. I think that the collateral is definitely going to get more scrutiny. think about commercial real estate. We serve a community bank market. So think about, banks from, a hundred million dollars to 20 billion dollars they're heavily reliant on real estate. So if you think about the collateral associated with that, the analysis is going to be more important now than ever, making sure that that's, all buildings aren't the same. All occupancies aren't the same just because it's, real estate doesn't necessarily mean it's good collateral given the changes we've seen in the real estate market. So I see that as extremely important now to discern the quality of that collateral and understand it better now than ever,
Bryan Peckinpaugh: So, so knowing that I think we're collectively on the same page, five C's of credit, important now, important forever, maybe shift the conversation a bit of, okay, if we all agree, then how do we ensure that is part, an appropriate part of what I do as a financial institution? How do I embed those five C's and give myself control over how much they weigh into the decision processes. I think it becomes very interesting of what can I do to take some of these, subjective criterias and try to make them objective. now maybe more than ever, the importance that technology can play in how I think about the five C's. And, can I leverage the technology that I have to look at different conditions differently? Can I separate by NAICS code so that I, use the other four C's differently for hospitality than I do for, commercial real estate than I do for general C&I lending. does, does my technology empower me to do that? Can I separate that out? Maybe you have different workflows for those or different underwriting criterias, different credit policies.
How do I build those five C's? Not just into the decisions that I make, but into. and sorry, the decisions that I make for new origination, but build that into my portfolio review as well. making sure that all five C's carry through to how I look at renewing existing business or modifying existing business.
How do I analyze the capacity? How do I analyze the capital? Am I getting all of the appropriate information in and using maybe third party data sources to find capital that not only is at my financial institution, but that they have elsewhere or at a wealth management firm or what have you. So, so David, what are your thoughts on embedding the five C's into the technology you use
David Catalano: I think it's a must. And if you don't do that, how are you analyzing the data? How are you analyzing how the portfolios perform? If you think about it, you're a quantitative portfolio manager if you're a bank. You have to be able to dissect the loan, the credit quality, The characteristics of the borrower, whether it's a corporate borrower or a guarantor or a combination of those two in a lot of businesses that it, the way that business goes is a function of that owner. So how are you characterizing that? And then discerning whether or not that asset class is as healthy as you think it is and has the right say allowance tied to it or, or should be added to the portfolio or reused from the portfolio. So I think you have to have a system where you can dissect the data. We had a client come to us and they couldn't even report on NAICScode, portfolio concentrations and couldn't put a pipeline report together. So just some basic reporting, but we see that it's 2 billion bank. We see that, over and over and over. And if you don't have the data and you can't slice and dice that data to, understand the portfolios you're building, you could be potentially building yourself a huge problem. You absolutely have to be able to use data and a quantitative approach to the underwriting and dissect all of these C's in different, segments, different mix codes, different sizes, different collateral types, just so you can understand what you're sitting on and what you're building and what you're going to get more of and what you're not going to get more of.
Bryan Peckinpaugh: now? I'm not ready to try to, automate and build into systems the character component that starts to get a little. Scary little, black mirror like for anybody that's watched the Netflix show. But I, the other four obviously are critical in my opinion. How does your technology empower you to, look at those as objectively as possible? Make sure that you, you can analyze the data, be able to build in my financial analysis to ensure that the capacity is there, bring all of the data together from disparate systems to analyze where the capital exists, supplemental data sources, to support what I have on my core.
Like you were saying, David, with the NAICS codes, the condition analysis, what's going on in different markets. How do I feed that in and separate, segment my new loans and my existing book of business and, making sure I'm managing that collateral well, which typically requires you to go beyond the core, to handle things like cross collateralization, lean position, et cetera and having a view of that when you make your decision, not having to hunt and peck for it, but having it all in one place so that I can make good solid credit decisions on new business. that I can point that same lens towards my portfolio and the more that I can create a feedback loop. So the more that I can take it out of people's heads and build it into technology, have my technology alert me when things are falling outside of what I think is good in the, in the five C's.
Really more four cause again, I would take character out of that, but, alerting me when, when things are outside of those parameters, leveraging, hard facts and data to make the decisions and using that to determine what good looks like for me. So using that to inform back to my credit policy, so that I can have a continuous feedback loop, allowing me to make more sound credit decisions and, and change it as necessary as those conditions change.
David Catalano: Yeah, that makes tremendous sense Bryan. Absolutely. Basically, it's a data driven approach and you just need to have the data. You need to be able to analyze that in a way that's easy. If it's hard, people don't do it. It's just human nature. We need to make it easy for them so they can just critically think about what they're looking at, not have to spend, all of their time trying to build it, trying to get to what should I be looking at? Here's what you should be looking at. Now, what does it tell you?
Mitch Woods: Yeah, I think that's the big thing, right? We all sit on every business sits on mounds of data, but it's about how do you interpret it and and give yourself that competitive advantage? How do you slice and dice it and look at it in different ways that are going to help you make data driven decisions? So I think my takeaway from this conversation is really it is kind of back to the basics, but it's not it's not backwards to the basics. It's looking forward to how do we apply the technology that we have available today to help us analyze the data that we're sitting on as a, as a bank or a credit union. To, to really understand my portfolio, to understand my credit policies, Bryan, I like your idea, that concept of the feedback loop, right? That's, that's really what's going to help set, set you apart is being able to act on the data that you have. So Bryan, David. Thank you guys both for, for your insights today, kind of a fun conversation talking about, some, some banking history, but also looking to the future as well. So, so thank you guys and thanks everybody for listening in to today's episode of Lending Made Easy.