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Understanding Commercial Loan Classification

Following the financial crisis, the risk management policies of financial institutions are under greater scrutiny. Although banks have always had a duty to control risks – in part through loan evaluations – financial institutions must more effectively identify loans that are at high risk of default and take actions to avoid losses whenever possible.

The Federal Deposit Insurance Corporation (FDIC) advises banks to adversely classify the following loans:

  • Substandard – A substandard loan is backed by inadequate collateral and insufficient paying capacity of the borrower. The bank is likely to sustain some losses unless the business corrects the deficiencies.
  • Doubtful – Because of the deficiencies, collection or liquidation of a doubtful loan is improbable.
  • Loss – A loan becomes classified as a loss if it is uncollectable and now carries such little value that it can no longer be considered a bank asset. The loan may be classified as a loss even if the bank can collect some of the money or salvage value at a future date.

Banks are required to protect against loss by maintaining reserves for the classified loans. Clearly, tying up its funds is not in a bank’s best interests. The bank has incentive, as does your business, to work out a deal that puts the loan repayment back on track.

Taking steps to prevent your loan from being adversely classified is ideal. However, if your loan is classified, the next step is a workout to rectify the deficiencies. Here are some strategy tips for a successful workout

  • Communicate regularly with your bank to prove you are taking steps to improve your business’s financial situation.
  • Collect on your accounts receivable as quickly as you can to support cash flow.
  • Avoid missing payments, but if you absolutely cannot make a payment on time, notify the bank with a definite date.
  • Negotiate with trade vendors to convert your accounts payable to notes payable to lower your debt service.
  • Reduce your owner’s draw if possible until your business is safely out of the red.
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