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Be Proactive With Credit Risk Management

By: Stephen G. Sargent

Over the coming months, the banking industry will continue to undergo fundamental changes ó with or without the comprehensive regulatory reform package that the Obama administration has proposed. Every week we hear about more and more banks that have been closed or are being investigated by federal regulators for unsafe and unsound banking practices. And that trend is expected to continue.

What remains to be seen is how much longer and how deep a cut this banking crisis will make on the U.S. and global economies. Although some leading indicators predict that the current recession may ease by the end of the year, we all know that answers to the crisis will be sought, regardless. Beyond the regulatory changes we are already experiencing in the mortgage and credit card arenas, additional reprimand and oversight is coming.

The combination of real property devaluation, suspect lending practices and regulators trying to save face in light of public and congressional outrage has already led to a situation that seems reminiscent of a witch hunt for offending financial institutions.

Granted, examiners have sufficient cause for many of their actions, but the side effects are that traditionally conservative, yet unprepared, banks are becoming entangled in the mire of new ó or newly enforced ó regulations.

If they havenít done so already, institutions must act now to shore up their current credit risk practices as well as their approaches to compliance oversight, and enact meaningful changes before examiners come knocking.
And for those already in hot water, itís not too late to make needed improvements to their lending operations. But the questions remain: What methods and solutions are available to meet the demands of current or future regulations? Can institutions manage risk in a way that not only protects their capital base but also helps them competitively serve their communities?

Become Proactive, Not Reactive

To avoid problems with examiners, banks must develop a definitive and proactive understanding and control over their loan portfolios. Institutions canít simply react to local competition in their lending practices without having a defensible policy in place. Such situations raise red flags for examiners.

Banks must create more thought-out policies and procedures for their lending operations ó plans that focus on enhanced risk management, increased consistency and improved efficiency. The key, of course, is underwriting, where consistency and quality, as manifested in a credit scoring strategy, is now, more than ever, becoming a focal point for examiners.

Best practices include ensuring the correct form of preparation for examiners before they arrive. This may sound obvious, but it often proves complex when one considers the new, more in-depth types of information regulators are beginning seek. Institutions should show initiative by putting processes in place that not only easily and quickly prepare the documentation, but more importantly, also provide relevant justification to defend lending practices and decisions.

Reporting and underwriting methods have long been hindered by traditional, manual processes ó like spreadsheets ó to analyze and score credit applications. This cumbersome, paper-filled system is no longer effective and can present an administrative nightmare for banks and regulators.

Automated credit risk management systems like loan origination software provide tools for application entry, underwriting and reporting that banks can use to track and manage their current lending trends. These systems can quickly provide proof to regulators that lending practices are indeed fair, safe and sound.

With an automated system, banks can create a consistent lending platform that helps loan officers easily manage credit requests while ensuring they donít forget or omit any important procedures or rules.

An effective system should also provide proactive management of employee proficiency, which includes underwriter performance monitoring. With these features, banks can capably control credit risk by developing a reporting system that ensures an institutionís lending personnel efficiently provide quality loan decisions.

The use of technology, though, does not mean lending must be devoid of all personal, human touch. Automated tools bring science to the relationship with fast, consistent loan decisions, but in the end, applying for a loan still involves one-on-one interaction between the applicant and the bankís lending staff.

Demand Better Loan Decisions

While reporting and underwriting consistency are important for all institutions, another vital factor that can keep examiners satisfied is the ability to quickly and prudently adapt or modify credit risk policies when warranted. The first step toward this goal is to reassess lending policy to ensure a fit with current market conditions. During times of financial crisis, itís natural for institutions to take a more conservative approach to lending.

This trend is currently illustrated in a recent report by the Office of the Comptroller of the Currency, which confirms that banks are continuing to tighten credit standards for the second year in a row. In fact, of the banks surveyed, nearly 70 percent indicated that they had tightened credit in an effort to reduce risk.

This said, taking a more conservative approach is not necessarily the correct path if bank policy is already predicated on conservative strategies. The answer may be ensuring more effective internal controls around existing strategies. Effective control requires a credit risk-based loan origination system that can enforce lending policies in an efficient and intuitive manner.

Also important to managing risk is the deployment and proper understanding of scoring models and credit scorecards. Itís not enough to simply have a scoring strategy; it is also essential to regularly validate the underlying scorecards, particularly in the case of a material economic event, to determine their continued effectiveness. This process ensures that the scorecards continue to effectively rank-order credit risk in your portfolio.

Even if you confirm that higher-scoring loans perform better than lower-scoring ones, you may find that the characteristics of your applicant population have materially changed. In such a case, your score cut-off strategy may need to change to compensate for the new risk environment.

Institutions can obtain online score benchmarks, known as odds of loss charts, from credit bureaus to aid their validation efforts, but they should ensure all benchmarks are corroborated against their own business to ensure accuracy.

Lending technology can help institutions securely establish and manage scorecards, while monitoring the status and success of any specific change or initiative. These systems can also help banks manage other important credit risk factors, such as risk-based pricing strategy and policy exceptions.

With bank examiners and new regulations looming, now is the time to make the necessary investments to change and enhance lending operations. Beyond the regulatory aspect, loan volume wonít stay low forever. Changes should be made before activity picks up again, because in todayís banking environment there is nowhere to go but up.

Stephen G. Sargent is president and CEO of Cypress Software Systems LP. Contact him at ssargent(at)

Copyright © November 2009 BankNews Publications