Publications & Resources
July/August 2009
Focus: Risk Management
Fine-Tuning Credit Risk
By Jeremy D. Taylor
In today's volatile economic and regulatory environment, it's critical that risk management be recalibrated, especially with regard to credit risk. Here are 10 practical fine-tuning steps any bank can take.
1. Review
risk-grading policies, procedures and practices.
Risk grades serve two critical functions: they should clearly
differentiate loans by risk of loss, and they should be responsive to underlying
changes in creditworthiness. A high concentration (say, more than 50%) of
loan exposure in one risk grade bucket may indicate that the system is not
functioning as it should. This threatens the integrity of the ALLL process,
of loan pricing guidelines, and of various credit administration practices. Addressing
this requires clear credit policy guidelines, and at least annual review of
every loan (including term loans not subject to annual renewal) by a lending or
credit officer, validated by a sample-based, independent credit review.
2. Conduct
more frequent and rigorous credit reviews.
This isn’t a place to skimp. Most institutions currently conduct at
least semi-annual credit reviews and have expanded sample sizes. Look for
patterns – weak underwriting, ineffective monitoring – and for emerging
trouble areas. Loan problems started in residential lending, have spread to
CRE, and are now showing up in general C&I. Recognize that credit
review should also consider portfolio effects such as loan concentrations. Use
the enterprise risk assessment (ERA) process to adjust priorities. If a credit
calls for more attention (and audit spending is tight), then the ERA should
reveal areas of internal audit that can be more safely trimmed this year or
deferred till next.
3. Conduct
adjunct loan documentation reviews.
When a loan defaults is not the time to find out you've got collateral
deficiencies. Are the boarding, documentation, monitoring and other loan
operations processes subject to clearly-written procedures that are regularly
reviewed and updated? Critical elements of the internal control environment
such as segregation of duties, dual control, and review and reconciliation (with
management sign-off) should be codified.
4. Put teeth
into your covenants.
Building covenant protection into loan agreements isn’t much help without
tight monitoring…and forceful action when circumstances warrant. Late
financial or other information from a client can be a useful early-warning
signal (EWS). Ditto for a failed financial test. Yes, the client may
still be current on their payments and returning your phone calls, but don’t
let the early-warning role of covenant protection be one of those things you
only recognize in hindsight.
5. Ensure
other loan policies and procedures are current and clear.
OREO, for instance, isn’t something banks have had to pay much attention
to for a while. But as holdings have climbed, new regulatory guidance was
recently released (FIL-62-2008). ALLL is another obvious example (i.e., the
2006 guidance statement). Make sure your policies are compliant and being
followed. Subject the full credit policy document(s) to annual Board review
and approval, and encourage directors to do more than rubber-stamp.
6. Implement
stress-testing, concentration limits and other portfolio-level tools.
These are spelled out for CRE loans in the 2006 Interagency Guidance on CRE
Concentration Management. But banks should be looking at them for other
loan concentrations as well – e.g., major industries, geographies. The
point is that you can miss a loan here or a loan there, but the real danger
comes if you’ve got correlated credit exposure (i.e., portfolio
concentrations) and a common loss factor at work, which can truly “bring down
the bank.”
7. Upgrade
portfolio data and reporting.
Make sure new loans (and to the extent possible, back-filling on existing
loans) capture requisite client- and loan-level detail. Map out these
requirements, especially for CRE loans. Make sure your MIS infrastructure can
accommodate, manipulate and report the necessary summary information.
8. Refresh
appraisals.
Standard practice may no longer suffice in this environment. Consider
more frequent updates than FIRREA requires, and perhaps second opinions or other
safeguards. Setting lower acceptable LTVs (loan-to-value) is a natural
corollary.
9. Train and
mentor junior lenders.
Many of a bank’s more junior lenders have never gone through a credit
downturn, or at least one as severe as we face today. It’s critical that
experienced lending officers take time to “teach the ropes,” including
identifying EWS and appropriate responses. Supplement with outside training
if necessary.
10. Keep the
Board informed and involved.
Good governance and control starts with the Board. Are they getting more than
just the Problem Loan Reports? Trends in portfolio credit quality,
comparisons with peers, emerging areas of stress, concentration management
(including limit compliance), exceptions tracking – all these are critical
components of Directors’ Loan Committee reporting (and in summary form to the
full Board). But it shouldn’t be an indiscriminate dump of data. Prune,
hone, explain. When it’s time to review policy documents, highlight
what’s changed and why. Encourage substantive discussion, not just on
individual credits but on the portfolio-level issues that determine credit
appetite and strategy.
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