The cannabis industry needs standardized methods of risk assessment

Matthew Staver/Bloomberg

The cannabis industry has long struggled with obtaining fair and equitable lending due to its product's classification as a Schedule I substance under federal law, a classification that has led to what some perceive as predatory lending practices. With the recent announcement that the government will reclassify cannabis as a Schedule III substance, the dynamics of lending in the cannabis sector seem poised for significant change, regardless of when reclassification takes effect.

It's easy to dismiss cannabis as "too risky" due to the stigma and long-standing federal classification. But banks and institutional investors should put cannabis on their radar and invest some time and effort to develop an understanding of the current lending landscape. As federal restrictions loosen, a determination of data-driven risk assessment will be necessary to securely and cost-effectively lend to cannabis companies. Furthermore, risk monitoring of debt can substantially reduce the cost of collections and prevent the potential of default, important factors in determining capital allocation by financial institutions.

During the 10 years of legalized adult-use cannabis, there has not been a standard for evaluating risk. State regulators do not look at the financial risks associated with lending to the industry and are primarily charged with compliance and operational oversight. While they are required to investigate and approve equity investments and ownership in cannabis businesses, they generally have no oversight into debt financing of the industry. This lack of transparency may have allowed for certain lending practices to exist that have increased the cost of capital for cannabis related businesses, or CRBs.

Lending in the cannabis industry has often been deemed predatory due to the high interest rates, unfavorable terms and limited financing options available to CRBs. Add to that the costs to CRBs operating in over-regulated and over-taxed state markets and you have a very challenging and volatile marketplace with lots of risk to capital. The lenders who choose to provide capital to the cannabis sector must do so in this unique environment. They need to balance these risks, so they often impose higher rates and stringent loan terms which — on the surface — might appear to be predatory, but are ultimately the cost of doing business in cannabis today.

A key impediment to lowering the cost of capital for the industry is the lack of a standardized method for evaluating risk associated with cannabis businesses. Traditional risk assessment tools do not account for the unique challenges CRBs face and often overlook key risk areas like compliance, character and operations. The lack of robust and objective risk evaluation standards has been an important factor in the higher costs of capital in the industry.

The ability to aggregate, process and evaluate data will be an important and critical tool for lenders to more fully understand the financial health of CRBs and accurately assess risk. As a better understanding and rating of risk becomes available, there will be more informed lenders likely offering more competitive rates to CRBs by aligning rates with risk, improving the overall health of the industry. An increase in participation by new banks and lenders will promote industry growth as more capital becomes available, allowing for further expansion of operations and brands leveraging economies of scale. Transparency in the true costs, operations and financial health of CRBs — significantly lacking in cannabis today — will improve, making it easier to determine risk and fair market value of businesses and the products they offer.

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The Drug Enforcement Administration's recent announcement that it will reschedule cannabis as a Schedule III substance — at the urging of the Biden administration — could alleviate some of the financial uncertainty surrounding the industry. It will likely reduce the stigma and perceived risk associated with cannabis and encourage more equity and debt financing into the space.

Regardless of federal reclassification, state regulators will continue to govern the industry across the country. Strong financial practices and the need for compliance, audits and risk management will remain priorities for lenders. Financial institutions will still face challenges in sorting through risk analysis and managing costs as state regulated cannabis markets will remain federally illegal. Staff hours and the niche expertise necessary to gauge and manage risk of CRBs on a daily basis will likely remain the same under Schedule III. Financial institutions will need to rigorously evaluate and understand potential risks to their lending based on comprehensive data analysis. Banks will need new cannabis lending policies in place and be able to provide evidence of objective risk analysis in the case of audits. In short, while rescheduling may reduce some federal tax burdens and begin to normalize the banking of the industry, the fundamental difficulties of lending to federally illegal businesses will persist.

In spite of those challenges, more banks are considering lending to the cannabis industry as new state markets open and a chorus of federal regulators and policymakers have signaled they support federal reform for cannabis banking. By expanding into the sector, they can tap into a lucrative market segment with above-market rates and favorable loan structures. Some will see this as an opportunity to replace revenues lost in other areas of their portfolios due to a slowing global economy. Additionally, CRBs will want more banking services as the industry continues to mature, including lines of credit and loans based on their credit worthiness. When you take all of these factors into consideration, banks should prepare today to take advantage of this new asset class in their lending and investment portfolios.

As cannabis moves toward a new classification, and more financial institutions enter the lending markets, CRBs that have had limited options will see improved financing choices and better rates that will help them grow and thrive. Financial institutions will benefit from the new revenue streams and the development of this new asset class. State regulators will have higher confidence in the working capital and new financial resources fueling industry expansion. Ultimately, the rescheduling of cannabis and the development of lending policies based on data-backed risk analyses will foster a more robust and equitable financial landscape across the industry.