Publications & Resources
July/August 2008
Focus: Lending & Credit
Revisiting Credit Quality and Risk Management
By Rex Beach
The Financial Stability Forum – a group of representatives from major central banks, finance ministries, and international agencies – recently published an assessment of the present financial and credit crisis, along with a series of recommendations to strengthen the oversight and performance of the international financial system. It is both interesting and informative to review the root causes of the present crisis identified in the report, particularly because of the implications for future corrective action and the likely ensuing impact on the banking industry.
Poor Underwriting Standards
Loan originators made massive volumes of subprime loans,
beginning in late 2004, that could be serviced only if the rise in housing
prices never ceased to accelerate.
Poor Risk Management Practices
As the report states “…market participants severely
underestimated default risks, concentration risks, market risks and liquidity
risks, particularly for super-senior tranches of structured products.”
Structured products refer primarily to residential mortgage-backed securities.
Poor Investor Due Diligence
Many investors, including institutional investors with the
capacity to undertake due diligence, failed to do so. Such failure simply fueled
the rise and issuance of even more complex credit products. Further, many
investors relied on credit rating agencies, which frequently failed in properly
assessing risk.
Poor Performance by Credit Rating Agencies
The credit rating agencies were not up to the task, failing
on several fronts, including weaknesses and deficiencies in rating models and
methodologies, inadequate due diligence, insufficient transparency or clarity
about underlying risk assumptions, and insufficient attention to conflicts of
interest in the rating process.
Incentive Distortions
Among other things, the incentive schemes and packages in
financial institutions and among mortgage brokers encouraged volume at the
expense of risk considerations, reflecting intense demand by investors for
securitized credit products such as residential mortgage-backed securities.
Disclosure Weaknesses
Financial institutions frequently failed to disclose the
magnitude of risks associated with off-balance sheet activities, which added to
the crisis in confidence. If they
did disclose such risks, they often did so partially or with lack of clarity and
transparency.
Snowballing Feedback Effects
In a period of market turbulence and widespread suspicion,
asset write-downs immediately triggered questions about capital adequacy, which
forced asset sales, which further drove down asset prices and placed more
pressure on capital adequacy.
Regulatory Weaknesses
Finally, the report clearly states that public authorities
“…failed to take effective countervailing action, partly because they may
have overestimated the strength and resilience of the financial system.”
Looking Ahead
In sifting through the various causes, it becomes readily
apparent that a collapse in underwriting standards and adequate risk measurement
– through ignorance or omission – played a major role in explaining the
present credit and financial crisis. It stands to reason that regulatory
agencies will become particularly vigilant in reviewing each of these areas of
weakness or omission going forward, perhaps with extra vigor since they have
been so roundly criticized for failing to prevent the crisis.
In a practical sense, the banking community might expect to see renewed supervisory focus on the following issues:
- Quality of underwriting standards
- Effective application of underwriting standards
- Ability to monitor and contain risk
- Quality and timeliness of financial information underlying risk assets
In a word, watch for a renewed focus on credit quality, which has systems and personnel implications for every lender. The credit quality issues become even more relevant if the economy fails to rebound quickly and vigorously as it has after the last two recessions. A slower economy exerts far more pressure on company and property management to run effective operations, very likely under competitive and economic conditions that few managers today have personally experienced.
In addition, a vast number of lending personnel assessing credit and devising risk management schemes have not experienced a serious economic downturn in their business careers. Adding to the problem is the fact that credit training, once a staple in the banking community, has fallen by the wayside in the rush to develop business, book assets, and grow profits.
Rex
Beach is founder of Shockproof! Training in
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