OCC Provides Risk Management Guidance for Bankers Engaged in Asset-Based Lending Activities
Asset-Based Lending (“ABL”) can be a profitable business; however, this type of lending has some disadvantages and inherent risks that must be assessed and managed by banks to maintain a profitable model. Earlier this year, the Office of the Comptroller of the Currency (the “OCC”) issued the ABL booklet, which is new to the OCC’s Handbook. In this new booklet, the OCC provides guidance for bank examiners and bankers on ABL activities. This article provides an overview of this line of business and of the relevant highlights of this new ABL booklet.
ABL is a specialized loan product that provides fully collateralized credit facilities to borrowers that may have high leverage, erratic earnings, or marginal cash flows. These loans are based on the assets pledged as collateral and are structured to provide a flexible source of working capital by monetizing assets on the balance sheet. While troubled companies often rely on ABL to provide turnaround and recapitalization, ABL can be used by healthy companies seeking more flexibility in executing operating strategies without tripping restrictive financial covenants.
The main source of repayment for revolving ABL facilities is the conversion of the collateral to cash over the company’s business cycle. Adequate controls and close monitoring are essential features of ABL. ABL lenders also may provide term financing for borrowers requiring longer-term capital or funding needs.
Advantages and Disadvantages
ABL offers some advantages for both borrowers and lenders. For borrowers, ABL provides ready cash to support liquidity needs, funding for companies with seasonal industries and rapidly growing companies, and the borrowing terms and repayment schedules are generally more flexible. For lenders, ABL can be a profitable, well-secured, and low-risk line of business if the appropriate controls are established.
ABL, however, can present some disadvantages for borrowers and lenders. For borrowers, it can be more expensive than other types of commercial lending. Another disadvantage is that, typically, ABL allows the lender to take control of the borrower’s cash if the borrowing base declines to a level that cannot support the loan. For the lender, monitoring ABL can be expensive, time consuming, and susceptible to borrower fraud, especially when a borrower experiences financial difficulties or unpredictability of cash flows.
Fundamental and Inherent Risks
The OCC booklet describes the fundamentals and inherent risks of ABL. The primary risks associated with ABL include:
- Credit Risk. This is the most significant risk associated with ABL. A higher default risk is common among ABL borrowers. If properly controlled, however, ABL can result in lower losses in the event of default when compared to other types of lending. This assumes that adequate accounting, inventory control systems, and credit and collection practices are in place.
- Operational Risk. Due to the nature of ABL, this risk is elevated by inadequate controls for collateral or customer remittances and ineffective monitoring of the borrower’s financial condition.
- Compliance Risk. Although ABL is subject to the same compliance issues as other types of lending, ABL can be more vulnerable to certain compliance risks, including the termination of credit facilities, debt liquidation, and compliance with state and federal laws and regulations.
- Strategic Risk. ABL should be compatible with management’s strategic goals and direction. Management and lending staff should have the knowledge and experience to recognize, assess, and mitigate the unique risks of ABL.
- Reputation Risk. A Bank’s actions to protect its interests can diminish its reputation. Material credit, failure to meet the needs of the community, inefficient loan delivery systems, and lender liability lawsuits are examples of other factors that can affect a banks reputation.
In addition, the booklet expands on the Account Receivable and Inventory Financing booklet of the OCC’s Handbook, issued in March 2000. Expanded topics include ABL structures, credit analysis, evaluating borrowing liquidity, establishing a borrowing base and prudent advance rules, collateral controls and monitoring systems and credit rating considerations.
Prudent Risk Management Guidelines and Assessments
The booklet discusses prudent risk management guidelines and supervisory expectations. A bank engaging in ABL activities is expected to establish and maintain written risk management guidelines that include effective loan policies and underwriting standards. This is the result of ABL activities requiring intensive controls and supervision to effectively manage the inherent risks of this type of lending. A properly structured ABL transaction mitigates the risk of default by imposing controls on collateral and cash. The risk of loss may actually be less than with other types of commercial lending, provided that the transaction is appropriately margined against collateral and that prudent monitoring and control processes are in place.
The booklet also includes expanded examination procedures to assist examiners in completing assessments of ABL activities. The procedures include an internal control questionnaire and verification procedures to further support the examination process.
For banks and bankers participating in ABL activities, and for those considering adding ABL to their product suites, the new OCC booklet provides valuable insight to the regulators’ view of key ABL risks, management guidelines, and examination procedures. Therefore, banks should carefully review this booklet to determine which guidelines should be implemented as part of their overall business strategy.
1 In this Article, national banks and federal savings associations are referred to collectively as banks.