Due diligence: two important words for all those who wear the white hats

RMA Journal, The, Oct, 2004 by Harris S. Berger, William F. Gearin

Does anyone believe borrower due diligence is no longer a core requirement in good lending practices? This article seeks to convince you of due diligence's increasing relevance in an intensifying fraud environment and discusses broad parameters for a due diligence program. As any seasoned lender will tell you, recognizing red flags is an important key to an effective due diligence program. This article captures those flags to help you mitigate fraud in your institution.

$300 billion in losses from failed S&L institutions accrued during the second half the 1980s--a "mortgage" that U.S. taxpayers will likely absorb until 2020. (1) This amount does not include the billions lost in the commercial banking industry.

It makes us wonder what else we could have done with $300 billion. Here's just one possibility: It could underwrite the construction of 1.25 million $250,000 homes; 25,000 homes in each of the 50 states would produce construction jobs, the purchase of home-building supplies, and ultimately real estate tax income. Here's another possibility: It could finance a four-year college education for 3 million young Americans.

You, too, can lose $300 billion. Here's all it takes:

* Work without accountability.

* "Make" the loan rather than "secure" the loan.

* Make uninformed decisions.

* Ignore the three most critical C's of lending--character, capacity, and collateral.

Let's take a moment to focus on the first of the three C's mentioned--character. While capacity and collateral are important components in making a loan, the character of the borrower is paramount. Remember: An individual may develop financial problems during the life of the loan affecting capacity and collateral, but a borrower with character will find a way to fulfill the obligation.

Historically, banks have done a remarkably good job in gathering information and documentation from the borrower, and many hours are spent analyzing the information obtained. However, they do an extremely poor job of verifying the information they gather and analyze! Two classic cases prove this point beyond all doubt (see sidebar, Con Tests) and are prime examples of the often repeated axiom, "Sophisticated crooks don't steal money--they simply take money banks give away."

Watch Your Back Side through X-Ray Vision on the Front Side

If the banking industry were reduced to a graphic form, we would watch the upward spiral of growth over a five- to seven-year period, then a crash downward when the economy takes a nose-dive, at which time the government tightens regulations, credit dries up, and lenders become collectors. Eventually, the cycle begins anew, and we begin to have trouble hearing the plaintive cry for due diligence before the loan is funded. If we did keep that call of due diligence in mind, the graph would be different. Instead of soaring and diving, we'd see a steady upward growth of profitability.

You may be asking whether there realistically is time to perform proper due diligence today. In many cases, a fair amount of time passes between the application for a loan and final approval. This is the time in which to perform suitable due diligence--from within, if the bank is large enough to support an in-house operation, or through outsourcing to companies or skilled individuals who have networks they can tap to verify data and information. (2)

Many banks are now implementing in-house due diligence services. With computers and skilled operators, vast amounts of information can be screened and reviewed. While computers have enhanced the ability to obtain background information, it is important that someone with "street smarts" interprets it and applies it. Since 9/11, we have heard many government officials--members of Congress and others--express the need to redevelop "human intelligence." Volumes of information can be produced, but it takes judgment to interpret information and apply it to a given loan situation.

Several conditions in the current lending market--all tied to competition--strongly reinforce the need for due diligence:

* Spreads that once were in the 4-6% range are now compressed to 150-250 basis points. This creates a very narrow margin for error.

* Competition among lending institutions compromises policies and procedures in the credit and loan departments.

* Goal attainments with financial rewards are clouding lender judgment. Promotion within the department or to the next level of supervision--predicated on overall performance rather than monetary bonuses--is a sounder method of management.

Going forward, we must become agents of change by putting into practice some simple, proven methods of due diligence. In turn, these methods will make a significant contribution to the safety and soundness of our institutions in an ever-changing environment.

Establishing a Due Diligence Program

Each bank's ultimate goal in setting up a due diligence program should be learning the true identity of all customers so that its lenders deal only with customers of sound character and reputation. This is a proactive approach, with each business line within the institution establishing policies and procedures for conducting due diligence investigations for both new and existing customers. Established parameters reflect in large part the nature of the business line's customer base and transactions.