Credit risk management in an asset-based lending environment

RMA Journal, The, July-August, 2004 by James Heitmann

The need to monitor the performance of collateral on an ongoing basis makes asset-based lending labor intensive, often requiring a significant investment in information systems and specialized personnel who have intimate knowledge of the borrower's business. Here is how it's handled at GMAC.

Credit risk management has improved with age. In the past 10 years, in fact, improved analytics, derivative and structured credit products, and growing liquidity for loans in the secondary market have brought a healthy glow to the field. And now techniques long used for managing large corporate borrowers are successfully being applied to middle-market lending.

Financial services companies--such as GMAC, whose portfolio of commercial credit risk is made up primarily of asset-based loans (ABL)--face particular challenges that require a slightly modified approach to measuring and monitoring credit risk. Unlike traditional cash-flow-based bank loans, ABL relies less on the borrower's financial and operational performance and more on the quality of the underlying collateral.

The GMAC Credit Risk Management Framework

With assets exceeding $275 billion, GMAC ranks among the 10 largest U.S. banks. While GMAC competes with commercial banks in many different markets, as an asset-based lender GMAC markets its financial services primarily to small to mid-size borrowers that have limited access to the capital markets for financing. The loans are generally illiquid and highly structured. In addition, the borrowers tend to be highly specialized. A large financial services firm, GMAC has products and markets that are extremely heterogeneous and diversified. Thus, the credit risk management framework needs to be extremely flexible to be applicable across all business lines. At the same time, while GMAC has aimed to develop a common framework across all its credit--granting activities, the framework also needs to have the capability of being tailored, when necessary, to be relevant to all the businesses. The need for this flexibility is extremely important within the context of asset-based lending, which frequently involves fairly complex structures with a wide variety of different collateral types.

The GMAC credit risk framework is based on a uniform risk-rating scale that ultimately will be applied to all subsidiaries and that seeks to harmonize all commercial and retail credit activities across the corporation. A new 23-grade scale--designed to closely mimic those of the major commercial credit rating agencies--is based on the notion of expected loss and provides the granularity necessary to effectively measure true credit risk exposure. Over time, GMAC plans to use the same risk-rating scale to assign both borrower and facility ratings to all of its lending transactions. A clear benefit of the universal scale is that it enables apples-to-apples comparisons across different borrowers, businesses, and product lines, which is critical to good credit risk management. The goal is to create the basis for firm-wide credit portfolio management.

The Challenges

An asset-based loan is usually secured by a borrower's accounts receivable, inventory, equipment, or other tangible asset. ABL is generally designed to address borrowers' short-term financing needs by allowing them to monetize the assets on their balance sheets and thus accelerate their cash collection cycle. The typical candidate for an asset-based loan is the small to medium-sized firm that is more often than not thinly capitalized but has a strong asset base. Other good candidates for this form of financing include companies in cyclical industries and newer firms lacking a sufficiently long operating history to qualify for conventional bank financing.

While the quality of the borrower is important--liquidation of the collateral is never seen as the primary source of repayment on the loan--an asset-based lender focuses on the quality, liquidity, and performance of the borrower's asset base coupled with the length of time required to turn the assets into cash.

The basics. In the standard asset-based deal, the borrower is provided with a revolving credit facility that may be drawn down to any amount up to a specified percentage of the value of the eligible collateral. The amount of eligible collateral that the lender is willing to advance against at any time is called the borrowing base. Understandably, the borrowing base will fluctuate up and down as inventory is sold and receivables are turned into cash. The amount advanced by the lender will vary based on the quality and performance of the collateral, providing the lender with a cushion in the event that the borrower is unable or unwilling to pay and the underlying security needs to be liquidated. Typically, there is a direct relationship between the quality of the collateral and the advance rate employed by the lender. One key challenge from a credit-risk-modeling perspective is developing a methodology for rating facilities that is robust enough to accommodate the unique structural aspects of an ABL transaction. Typically, ABL transactions are highly structured. This makes it difficult for any off-the-shelf products to work.