There have been more than 400 bank closures since 2008 and most of them were closed because of failure to adequately manage credit risk. How a bank selects and manages its credit risk is critically important to its performance over time, and capital depletion through loan losses has been the primary cause of most institution failures. Setting proper risk tolerances is the first step in effectively managing credit risk.
Setting Risk Tolerances
Good credit risk management starts with setting and communicating reasonable credit risk tolerance levels. This is the board of directors’ responsibility and cannot be delegated.
Banks that had the most problems during the past four years failed to adequately establish risk tolerances related to industry risk. Basically, the boards of directors failed to establish reasonable limits on industry concentrations to guide senior management. For example, banks that did well during the past four years had limited construction/land development loans to less than 5 percent of capital. The banks that failed had much higher limits or failed to properly monitor their concentrations at all.
The board of directors should be clear in what it wants the portfolio to look like. Here is good place to start:
Determine the percentage of commercial, residential and consumer loans you would like in your entire portfolio.
Determine what you want each of the above portfolios to look like.
For your commercial portfolio, set the percentage of commercial mortgages, commercial and industrial loans, and construction loans; the level of loans in each industry (retail, manufacturing, service); level of owner vs. non-owner occupied for your CREMs; and by geographic location.
Determine what you want your residential portfolio to look like: residential mortgages vs. home equity loans; home equity lines of credit vs. home equity amortizing loans; and limits by geographic location.
How much consumer secured vs. unsecured do you want in the consumer portfolio?
Set goals by both percentage of total loans, percentage of each portfolio and, most importantly, percentage to capital. Drill down as much as you need to give the management team as much guidance as possible in developing a portfolio ideal.
Typically, a portfolio that is comprised of 60 percent commercial loans, 30 percent residential and 10 percent consumer is much riskier than 40 percent commercial, 55 percent residential, and 5 percent consumer. Also, a commercial portfolio comprised of 65 percent CREMs and 35 percent C&I loans is normally less risky than 30 percent CREMs and 70 percent C&I due to secondary protection provided by collateral. It is perfectly fine to take more risk; just make sure the institutions has the capital to do it.
In addition, have your risk tolerances reviewed by an experienced third party. They can bring that outside perspective that you will need. If you are experiencing credit problems, look to see if your loan review function has even assessed your risk tolerance levels. If it did not, include it into your scope for the next loan review.
Lastly, have management provide reports that track portfolio composition on a monthly basis, to include the performance of each of the above portfolios (i.e., weighted average risk ratings, percent of loans past due, percent non-accrual and losses). This way the board of directors will have enough information to direct management to stop booking loans in portfolio segments that are starting to show signs of deterioration.
Loan Review Function
Banks need to take a hard look at their loan review functions. Many banks rely on bank examinations to give them comfort with their credit risk management functions. This can put you into a false sense of security. Bank examiners are not auditors and most examiners have not made loans, managed loan portfolios or had to deal with a workout situation. It is not their job to do loan review at your bank. More than likely, they will rely on the work conducted by your loan review function to make conclusions about asset quality.
Many banks choose to have an in-house loan review function versus outsourcing the review. For most small to mid-size institutions ($50 million to $2.5 billion in assets), an in-house loan review function is neither cost effective nor sufficient to help manage credit risk. An in-house loan review function does not have the ability to review in detail what is transpiring at other institutions; it is essentially operating in a vacuum.
This can lead to not only missing early warning signs but also the function is unable to help improve credit risk management practices because it has no reference point. Plus, an outsourced loan review typically costs much less than what it would cost to support a full-time employee.
Look at the quality of your loan review function. What are its qualifications? Are you its only client? How is it risk rating loans? Does it have a methodology or is it mostly its opinion? Is it easy to follow how the risk rating was determined? Regardless of how the risk rating was determined, the methodology should be transparent and consistent and built on sound lending fundamentals. Properly risk rating loans is an essential step in managing credit risk, so take the time to make sure you understand how the risk ratings are being developed.
Risk-rating loans is not a simple process. If it was, we would not have had the failures we did. To properly risk rate a loan, you have to consider many variables. For example, although the debt service coverage ratio may be less than 1.00, that does not necessarily mean the credit deserves a criticized (special mention) or classified (substandard, doubtful or loss) risk rating. Suppose the borrower has excellent liquidity and collateral protection is good. What would be the risk rating now? What if the borrower is in an industry that has been significantly impacted by current economic conditions? How would that impact the risk rating?
A risk rating is dependent on many variables and how these variables interplay with each other. A risk-rating model should be mainly objective but still leave room for reviewer judgment. Here is one model for risk-rating loans that takes into consideration all these variables and ensures your risk-rating process is transparent and consistent.
This model is based on the proven fundamentals of lending, notably the five Cs of lending. Each of the following variables is reviewed for each borrower: 1) capacity (cash flow) to repay the loan; 2) collateral protection; 3) capital and other financial condition of the borrower; 4) character of the borrower and their willingness to repay the loan; and 5) conditions in the marketplace that may impact the borrower.
In addition, credit administration should be assessed to determine if the loan was structured properly for its intended purpose and if it is being properly monitored on an ongoing basis. Each variable is weighted based its importance to the risk rating.
For example, the capacity variable is weighted higher than collateral; the collateral variable is weighted higher than conditions. Criteria are developed for what information will be reviewed in each variable.
Each variable is rated as excellent, satisfactory or poor. A numeric rating system has been developed in order for the model to calculate the risk rating score. Again, criteria should be developed for the assignment of each score to ensure consistency in the process. Comments are used to fully support each variable rating.
Finally, the overall rating is compared to a risk-rating range that correlates to the bank’s risk rating system. This is the most difficult step of all and requires significant testing and experience to accomplish. Once done, however, this methodology will ensure consistency and transparency in your risk-rating process.
Managing credit risk begins with setting good risk tolerance levels. Loan review is a key function that helps measure compliance with these risk tolerance levels and ensures the portfolio is properly risk rated. Without a good loan review function, the bank could head down a wrong path. Ensure the loan review function receives appropriate attention and take the time to explore and invest in a risk-rating system that makes sense for your bank.
Bo Singh is president of T. Gschwender & Associates Inc., a diversified consulting company that has been providing services to financial institutions since 1984. Contact him at info(at)tgschwender-assoc.com.
Copyright (c) June 2012 by BankNews Media