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IN MODERN TIMES...
Know Your Customer Regulations
Take on a Higher Meaning
By Jerry Oldham
Know Your Customer regulations take on a higher meaning to those who manage risk at the level common to all asset-based lenders. In these days of increased balance sheet risk and uncertain economic times, it can be concluded that it is truly management that repays the loan, and there is no better way to assess management’s ability to run a company than to account for how management has performed in the past. |
JERRY OLDHAM
Co-Founder, Chairman & CEO,
1stWEST Financial Corp.
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The focus of this article is to speak to the need to Know Your Customer (borrower) in these difficult lending times and in today’s tough business environment. Simply put, in the U.S., Know Your Customer (KYC) for banks and federally chartered savings and loan institutions is a due diligence policy implemented to conform to a customer identification program mandated under the Bank Secrecy Act and the USA Patriot Act of 2001. Bank lending divisions and bank-owned commercial finance companies are, therefore, looped into these requirements. As best practices, other lenders have likely, by now, picked up on the requirements as well, although they are not mandated to do so. Taking this KYC to the appropriate next level for commercial finance entities, Enhanced Due Diligence (EDD) is the common practice of well-managed lending operations in modern times.
Yes, Know Your Customer regulations take on a higher meaning to those who manage risk at the level common to all asset-based lenders. KYC and EDD to lenders means consistently assessing the risk that would come from otherwise not knowing the real financial character and capacity of a prospect and its management team. In these days of increased balance sheet risk and uncertain economic times, it can be concluded that it is truly management that repays the loan, and there is no better way to assess management’s ability to run a company than to account for how management has performed in the past. The optimal way to do this and to best know your borrower is to perform a background investigation. Performing background investigations should be a regular part of a lender’s KYC policy and EDD process.
Know Your Customer (borrower) is really nothing new in the underwriting and due diligence process and nothing that should ever require a regulatory mandate. Among lenders that have had formal credit training, the four Cs of Credit – Collateral, Capacity, Conditions and Character – have long stood the test of time as the primary factors influencing the credit decision. It is the consistent assessment, measurement and monitoring of these four sacred principles that all lenders strive for today just as they have for decades, if not centuries. Know Your Customer is embodied in these credit characteristics. It is how we perform our due diligence that addresses these critical risk assessment factors that has changed over time. I will discuss later how the passage of time has elevated the importance of getting these four aspects of the underwriting process correct. |
Performing
background investigations
should be
a regular part
of a lender's
KYC and EDD process.
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But first, I would like to recap summarily the due diligence process of every asset-based lender.
The Lender’s Due Diligence Process
Broadly speaking, in addition to management interviews and site visits by the lender, the due diligence process often
includes the following key components, many of which are outsourced today because of the demand for the latest tools and
for specialization:
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Background investigations, including investigations performed upon the borrowing entity and the management team
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Financial statement reviews and analysis, including audits and field examinations
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Collateral evaluations, including appraisals of personal and real property
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Legal reviews of corporate fitness and business legitimacy
A Historical Perspective
My purpose here is to present the case for the utilization of background investigations as a tool to know your customer and to manage risk and prevent, detect and manage fraud – before and after the loan is made.
For the following reasons, the performance of background investigations as an integral part of the KYC and EDD process is more meaningful than in the recent past, and should be part of the pre-commitment, post-closing and on-going due diligence:
- Excessive and obsolete inventory levels, slower accounts receivable collections, increased dilution, deteriorating collateral values and reduced advance formulas make it critical that experienced management is at the helm and that it is not burdened by an illegitimate or unsavory past.
- Company owners and managers are involved in more businesses than ever, many of which are across state or country borders and may involve different and multiple partners. These “off-balance sheet entities” could be the host of a problem.
- Lenders are more often participating with other lenders and equity providers in the same capital structure, sharing increased risk with each other. Participants are relying upon the lead lender’s pre- and post-closing due diligence in most cases.
- The world market is a greater target for new business and new business partners, and lenders are more in need of the best worldwide information in order to make an informed decision.
- The media plays a more intense role and is ever more in real time. Lenders must know what the media knows and more.
- The world is ever more litigious, and litigation costs real time and real money. It is best to get the most accurate information up front in order to avoid a legal issue that could have been avoided.
- Information is more readily available within a time frame that beats the bell at a cost that doesn’t beat the bank.
- Lending relationships are frequently more transactional and less relationship driven. Banking services are often accepted by borrowers more a la carte, in spite of banks’ best intentions to cross sell expanded capabilities as the best value proposition.
- Time is more of the essence with competition for the same deal ever more intense and coming from ever more financing sources. Lenders and borrowers share the same desire for a speedy decision, requiring the fastest due diligence possible.
- Corporate fraud, scandals and corporate governance have become more common in our business vocabulary. Corporate scandals are now front-page news, and the executives convicted of these illegalities against shareholders, investors and lenders are being held accountable.
- There are now regulations that require a KYC policy and a certain level of background investigation. A few short years ago, there were no insurance requirements or federal statutes that required a state or national bank or federally chartered savings and loan institution to check a list for terrorists, narcotics traffickers or those engaged in the proliferation of weapons of mass destruction. The FDIC and the FSLIC changed all of that subsequent to the passing of the Patriot Act.
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Establish written
KYC and EDD
risk management,
due diligence and
background investigations guidelines
to live by,
and follow them
without exception. |
Best Practice Tips
Lenders should be consistent about the KYC and EDD methodology that they employ. Lenders that perform background by exception rather than as a standard practice could be compromised exceptionally – if and when it happens.
- Hire a background investigations firm that is consistent about its methodology as well. Ask the firm about its best practices methodology, and be sure it includes the next three items.
- An investigations firm’s best practices must include a thorough research effort into determining all of the jurisdictions (counties or countries) in which the subject has resided, owned property and done business. Research must be performed in every jurisdiction where it has been determined the subject has resided, owned property and done business. To except even one jurisdiction could be to leave out the one where the deal killer issue resides.
- An investigation into public records (i.e., civil and criminal litigation histories, tax liens, judgments and bankruptcies) should always include a combination of independent onsite and online research. We find adverse public record information in approximately 30% of the cases as a result of performing onsite research that we don’t find when performing online research only, using the best databases available, a percentage too high to ignore.
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Always check the Office of Foreign Assets Control (OFAC), a Division of the U.S. Department of Treasury, for Blocked Persons and Specially Designated Nationals. Those on this list are known fraudsters, terrorists, money launderers and financiers of these activities. This information is updated at least monthly.
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Establish a consistent monitoring system and track borrowers and managers periodically against their known history or “Risk Profile.” Things can change quickly over time, especially in a tough economy.
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A Few Truths to Live By
- Establish written KYC and EDD risk management, due diligence and background investigations guidelines to live by, and follow them without exception.
- Back up your best interviewing skills and intuition with the best information available.
- When in doubt, it’s always better to walk away from a deal.
- It’s always management that ultimately repays the loan. Discover the real truth about who the business owners and managers are.
- Maintain your sense of humor because, when the collateral is gone and you’re left to work out a deficiency with a known felon who has ravaged his last three ventures and committed untold acts of indiscretion, you’ll need it.
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Jerry Oldham is co-founder, Chairman and CEO of 1stWEST Financial Corp. Oldham has a broad senior management background in commercial banking and corporate and real estate finance. He frequently serves as a consultant or expert witness in litigation and settlement negotiations involving complex corporate finance, real estate banking and lending practice issues. Oldham often acts as a consulting team leader to manage the overall due-diligence process on investment decisions for 1stWEST clients. He received a B.S. in Finance and Real Estate from The Pennsylvania State University and an M.S. in Banking and Finance from Colorado State University.
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Reprinted with permission from ABFJournal (Vol.7, No.1). Copyright © 2009. All rights Reserved. |
