Why You Need To Diversify Your Debt

Challenging economic times or slow seasons in business can be disconcerting for business owners. The anxiety is compounded when banks reduce their risks in certain sectors (i.e. oil and gas).

How A Bank Reduces Risk

Banks are driven by sectors. They want to limit their exposure in industries where they feel vulnerable. If they decide they want to minimize risk in a certain area, they can also decide they no longer want to hold the financing on specific loans or lines of credit.

When a bank reduces its risk, they actually shut down lines of credit and demand full payment. Is this legal? Yes, it is.

A line of credit is basically a demand loan. Banks can legally “pull the plug” at any point in time. You don’t necessarily have to be behind on payments to have this happen.

People rarely hear about demand loans being called until extenuating circumstances happen (like an uncertain economy). But it does happen – and usually when you least expect it or are more vulnerable.

How Does This Impact You?

If you’ve put a big piece of equipment for your business on a line of credit and the bank decides to shut it down, you are left scrambling to find a way to pay off your equipment immediately, or risk business failure.

A bank often has a great deal of information about you and your business and where things stand from a financial perspective. This is not necessarily a good thing; it does not necessarily minimize your risk. “They’ve got your whole world in their hands.”

We’ve had clients who lost their business because the bank called their loan or line of credit (with as little as 5 days notice) for no reason other than an effort to reduce their risk. Our clients had done nothing wrong, had never defaulted on payments, were making money and business seemed fine. But the bank decided they were uncomfortable with the industry and wanted to reduce their risk.

The Importance of Diversification

Diversifying your credit risk is just as important as diversifying your investment portfolio.

The Organization for Economic Co-operation and Development (OECD) stated, “Small and medium-sized enterprises (SMEs) are fundamental for inclusive growth and jobs, but they need to broaden their sources of finance in order to reduce their vulnerability to volatile credit market developments… Alternative funding options must be developed and promoted to support investment.” (Source) (emphasis added)

That same source also says, “… traditional bank finance poses challenges to SMEs… diversified funding sources for SMEs can better serve the needs of firms at different stages of their life cycle, as well as help to mitigate systemic risk, strengthen the economy’s resilience to critical shocks and foster new sources of growth.”

Reduce Your Own Risk

So, is your risk really reduced by using a bank as opposed to a leasing company or other financing entity?

Some people  are nervous about using a less familiar form of financing than what they’re used to (banks). Before making a financing decision, be sure you understand your options and the advantages of each one. Here are some links to get you started:

Stay informed. Reduce your risk. Diversify your debt.