Portfolio Risk Management

There are a lot of areas covered in your comment: efficiency; credit quality (human side or character in an impersonal environment); and policy adherence. 

We define efficiency and effectiveness using these metrics:

• Turnaround time from application submission to decision;
• Resulting delinquencies based upon type of underwriting (centralized vs. decentralized);
• Production levels between centralized and decentralized;
• Performance of the portfolio based upon type of underwriting; and
• Turnaround time from application submission to decision

Due to the nature of Experian’s technology, we are able to capture start and stop times of the typical activities related to loan origination.  After analyzing the data from 160+ financial institutions of all sizes, Experian publishes an annual small business benchmark report that documents loan origination process efficiencies and inefficiencies, benchmarking these as industry standards.  

Turnaround Time

From the benchmark report, we’ve seen that institutions that are centralized have consistently had a turnaround time that is half of those with decentralized environments.

Interestingly, turnaround time is also much faster for the larger institutions than for smaller.  This is confusing because the smaller community banks tend to promote the close relationship they have with their clients and their communities. Yet, when it comes to actually making a loan decision, it tends to take longer.

In addition to speed, another aspect of turnaround is consistency.  We all can think of situations where we were able to beat the stated turnaround times of the larger or the centralized institutions.  Unfortunately, these tend to be isolated instances versus the consistent performance that is delivered in the centralized environment.

Resulting delinquencies based upon type of underwriting/Performance of the portfolio based upon type of underwriting

Again, referring to the annual small business lending benchmark report, delinquencies in a centralized environment are 50% of those in a decentralized environment. 

I have worked with a number of institutions that allow the loan officer/relationship manager to “reverse the decision” made by a centralized underwriting group.  The thinking is that the human aspect is otherwise missing in centralized underwriting.  When the data is collected, though, the incremental business/portfolio that is approved by the loan officer (who is close to the client and knows the human side) is not profitable from a credit quality perspective.  Specifically, this incremental portfolio typically has a net charge-off rate that exceeds the net interest margin -- and this is before we even consider the non-interest expense incurred. 

Your choice: is the incremental business critical to your success…or could you more fruitfully direct your relationship officer’s attention elsewhere?

Production levels between centralized and decentralized

Not to beat a dead horse, but the multiple of two comes into play here too.  As one looks at the throughput of each role (data entry, underwriter, relationship manager/lender), the production levels of a centralized environment are typically double that of a decentralized.

It’s clear that the data point to the efficiency and effectiveness of a centralized environment

• Maximizing client retention
• Maximizing cross-sell opportunities
• Minimizing loss potential due to credit-risk issues
• Minimizing loss potential due to operational risks
• Maximizing profitability through the timely identification o f risk and the appropriate allocation of capital

In addition to behavioral models, collections and account management groups need the ability to implement collections workflow strategies in order to effectively handle and process accounts, particularly when the optimization of resources is a priority. While the behavioral models will effectively evaluate and measure the likelihood that an account will become delinquent or result in a loss, strategies are the specific actions taken, based on the score prediction, as well as other key information that is available when those actions are appropriate.

Identifying high-risk accounts, for example, may result in strategies designed to accelerate collections management activity and execute more aggressive actions. On the other hand, identifying low-risk accounts can help determine when to take advantage of cost-saving actions and focus on customer retention programs.  Effective strategies also address how to handle accounts that fall between the high- and low-risk extremes, as well as accounts that fall into special categories such as first payment defaults, recently delinquent accounts and unique customer or product segments.

To accommodate lenders with systems that cannot support either behavioral scorecards or strategies, Experian developed the powerful service bureau solution, Portfolio Management Package, which is also referred to as PMP. To use this service, lenders send Experian customer master file data on a daily basis. Experian processes the data through the Portfolio Management Package system which includes calculating Fast Start behavior scores and identifying special handling accounts and electronically delivers the recommended strategies and actions codes within hours. Scoring and strategy parameters can be easily changed, as well as portfolio segmentation, special handling options and scorecard selections.

PMP also supports Champion Challenger testing to enable users to learn which strategies are most effective. Comprehensive reports suites provide the critical information needed for lenders to design strategies and evaluate and compare the performance of those strategies.
 

1.       Portfolio Management – You should really focus on this topic in 2009.  With many institutions already streamlining the origination process, portfolio management is the logical next step.  While the foundation is based in credit quality, portfolio management is not just for the credit side. 

2.       Review of Data (aka “Getting Behind the Numbers”) – We are not talking about scorecard validation; that’s another subject.  This is more general.  Traditional commercial lending rarely maintains a sophisticated database on its clients.  Even when it does, traditional commercial lending rarely analyzes the data. 

3.       Lowering Costs of Origination – Always a shoe-in for a goal in any year!  But how does an institution make meaningful and marked improvements in reducing its costs of origination? 

4.       Scorecard Validation – Getting more specific with the review of data.  Discuss the basic components of the validation process and what your institution can do to best prepare itself for analyzing the results of a validation.  Whether it be an interim validation or a full-sized one, put together the right steps to ensure your institution derives the maximum benefit from its scorecard.

5.       Turnaround Times (Response to Client) –Rebuild it.  Make the origination process better, stronger and faster.  No; we aren’t talking about bionics here -- nor how you can manipulate the metrics to report a faster turnaround time.  We are talking about what you can do from a loan applicant perspective to improve turnaround time.

6.       Training – Where are all the training programs?  Send in all the training programs!  Worry, because they are not here.  (Replace training programs with clowns and we might have an oldies song.)  Can’t find the right people with the right talent in the marketplace? 

7.       Application Volume/Marketing/Relationship Management – You can design and execute the most efficient origination and portfolio management processes.   But, without addressing client and application volume, what good are they?

8.       Pricing/Yield on Portfolio – “We compete on service, not price.” We’ve heard this over and over again.  In reality, the sales side always resorts to price as the final differentiator.  Utilizing standardization and consistency can streamline your process and drive improved yields on your portfolio.

9.       Management Metrics – How do I know that I am going in the right direction?  Strategize, implement, execute, measure and repeat.  Learn how to set your targets to provide meaningful bottom line results.

10.    Operational Risk Management – Different from credit risk, operational risk and its management, operational risk management deals with what an institution should do to make sure it is not open to operational risk in the portfolio. Items totally in the control of the institution, if not executed properly, can cause significant loss.

What do you think? As the end of April approaches, are these still hot topics in your financial institution?

This post is a feature from my colleague and guest blogger, Barry Timm, Senior Process Architect in Advisory Services at Baker Hill, a part of Experian.

2008 has proven to be an unbelievably challenging year for the economy as a whole, let alone the financial industry.  Never before have we experienced the type and degree of turmoil that we did in 2008, even since the “Great Depression”.
 

These economic challenges have been quick, severe and widespread; and, from large corporations to the individual consumer, all have been impacted to some degree.  The stock market is down, unemployment up, consumer confidence down, delinquencies up ….not exactly a pleasant roller coaster ride. 
 

And, there is no longer any projecting as to when the “bubble” is going to burst.  It happened.   Decreased real estate values have occurred not only in high impact geographic regions but throughout the country.  While home equity products have traditionally been the “golden child” of consumer loan product offerings, recent economic changes have caused a shift in that perspective.  As a result, tightened underwriting standards have limited the availability of the product as a whole.  In some markets the product offering has even been temporarily halted.
 

We frequently hear the terminology “bailout” being used in the news.  While we all have expectations as it relates to the bailout approach, I thought I would “Google” the word “bailout” to see what would magically appear.  Interestingly enough, the first listing was titled “Walk away from your home”, with a link to the home page for a mortgage default legal team.  This is not exactly what I was expecting to find, but is definitely reflective of the times.
 

And, according to the FDIC, there have been 25 failed financial instituions in the year 2008.  This single year number equates to the total number of failed financial institutions between the prior periods 2001 through 2007. 

Okay … enough doom and gloom.  In spite of all that has occurred within the economy, some financial institutions continue to maintain a strong credit quality position in their consumer portfolios and have maintained profitability throughout all of the market volatility.  

What are the strong survivors doing that differentiates themselves from the others?

1. They understand their portfolio.  
Advisory Services frequently assists clients with various types of portfolio management analysis and often presents those findings to senior management.  We often hear that management is surprised by the results of that analysis. The point is that high-level management reporting is not enough these days. Additional detail and depth are necessary. 

More specifically, as opposed to evaluating payment performance at the portfolio level, it is important to consider the following:

• Do you know your delinquency numbers at the product level? 
• How do delinquencies compare to your product approval rates? 
• Do you routinely compare approval/decline rates and delinquencies to scorecard results and/or credit bureau scores?  
• Do you know where pricing exceptions are being made and are you receiving sufficient return for the level of risk?

2. A focused strategy is in place.
It is important to re-emphasize the specific, strategic direction and focus of your defined market.  Now is not the time to be “pushing the envelope” and extending into untested waters.  There is something to be said about focusing on your strengths, staying within your defined footprint and meeting the needs of your core, proven line of business while following sound financial risk management.

3. The underwriting process is under control.
This does not automatically mean that a “tightening” of underwriting standards is necessary.  It does mean, however, that stronger attention to detail is warranted.  It is important that underwriting criteria is reviewed and that you are sure that defined underwriting practices are consistently applied.  As noted in item number one above, this may require digging a little deeper and reviewing current and past decisioned loans (preferably with a critical eye of an independent third party).  Assessing the underwriting process becomes increasing complex and more critical with a decentralized underwriting approach.

Focus on the positive
Now that 2008 is behind us, let’s continue to focus on the positives to come in 2009.  Reflect on the past, but strive to center your attention on ongoing portfolio monitoring, financial risk management assessments and improvements for the future. 

 

What is porfolio risk management? It is the active and effective oversight of the current client base with the intent of:

• Maximizing client retention –LOVE
  • Everyone wants to retain clients and deepen relationships!
• Maximize cross-sell opportunities –LOVE
  • Again, everyone wants to retain clients and deepen relationships!
• Minimize loss potential due to credit risk issues –HATE
  • No one wants credit issues to develop!
• Minimize loss potential due to operational risks –HATE
• Maximize profitability through timely identification of risk and appropriate allocation of capital –LOVE / HATE

• Which clients are likely to need additional products and services?
• Which clients have a high potential of leaving your financial institution?
• When do you shift from client retention to credit risk management?
  
   

Part 1

It may be quite useful to compare your financial institution's portfolio risk management process or your investment plans , to the results of peer group averages. Not all banks are the same -- believe it or not. Here are the averages. You should look for differences in your target institution. About half of them beat certain performance numbers and the other half may be naturally worse.

As promised, I have again reviewed the Uniform Bank Performance Reports for the two largest peer groups through the end 2008. The Uniform Bank Performance Report (UBPR) is a compilation of the FDIC, based on the call reports submitted by insured banks. The FDIC reports peer averages for various bank size groupings and here are a few notable findings for the two largest groups that covers 494 reporting banks.

Peer group 1

• Peer group 1 consisted of 189 institutions over $3 billion in average total assets for the year.
• Net loans accounted for 67.31% of average total assets, which is up from 65.79 % in 2007. 
• Loans, as a percent of assets, have increased steadily since at least 2004. The loan-to-deposit ratio for the largest banks was also up to 96% from 91% in 2007 and 88% in both 2006 and 2005.

So, it appears these banks were lending more in 2008 as an allocation of their total asset base and relative to their deposit sources of funding.

In fact, net loans grew at a rate of 9.34% for this group, which is down from the average growth rate of 15.07% for the years 2005 through 2007.  The growth rate in loans is down, which is probably due to tightened credit standards. However, it is still growth. And, since total average assets also had growth of 11.58% in 2008, the absolute dollars of loan balances increased at the largest banks.

• Peer group 2 consisted of 305 reporting financial institutions between $1B and $3B in total assets.
• The net loans accounted for 72.96% of average total assets, up from 71.75% in 2007. 
• Again, the loans as a percent of total assets have increased steadily since at least 2004. The loan-to-deposit ratio for these banks was up to 95% from 92% in 2007 and an average of 90% for 2006 and 2005.

So, these banks are also lending more in 2008 as a portion of their asset base and relative to their deposit source of funding.

Net loans grew at a rate of 10.48% for this group in 2008 which is down from 11.94% growth in 2007 and down from an average growth of 15.04% for 2006 and 2005. And, since total average assets also had growth of 10.02% in 2008, the absolute dollars of loan balances also increased at the intermediate size banks. Again here, the growth rate in loans is down, probably due to tightened credit standards, but it is still growth and it is at a slightly more aggressive rate than the largest bank group.

Combined, for these 494 largest financial institutions, loans were still growing through 2008 both as a percentage of asset allocation and in absolute dollars.

Tune in to my next blog to read more about the results shown relating to credit costs, loss allowance accounts and the impacts on earnings.
 

Part 1

Beyond the risk management considerations related to a bank’s capital position, which is directly impacted by Troubled Asset Relief Program (TARP) participation, it should be clear that TARP also involves business (or strategic) risk.  We have spoken in the past of several major categories of risk: credit risk, market risk, operational risk and business risk.

Business risk includes:

• A variety of risks associated with the outcomes from strategic decision making;
• Governance considerations; 
• Executive behavior (for lack of better terminology);
• Management succession events or other leadership occurrences that may affect the performance and financial viability of the business.

Aside from the monetary impact on the bank’s capital position, TARP involves a new capital securities owner being in the mix. And, with a 20% infusion of added tier 1 capital, we are almost always talking about a very large, new owner relative to existing shareholders. The United States Department of the Treasury is the investor or holder of the newly issued preferred stock and warrants. The Treasury Department does not have voting rights like common shareholders, but the Treasury’s Securities Purchase Agreement – Standard Form includes at least 35 pages of terms, plus the required Letter Agreement, Schedules attached to the Letter Agreement and at least five significant Annex’s to the Purchase Agreement. It’s NOT an easy, quick or fun read.

In the Recitals section, it states that the bank: “agrees to expand the flow of credit to U.S. consumers and businesses on competitive terms as appropriate to strengthen the health of the U.S. economy” and, later, “agrees to work diligently, under existing programs, to modify the terms of residential mortgages as appropriate to strengthen the health of the U.S. economy.” Fortunately, if you’re a banker, these topics are not (currently) revisited elsewhere in the document, period. However, these are examples of the new shareholder effecting business decision making without the need to be on the Board of Directors, or voting common shares.

The Agreement covers a number of other requirements and limitations, such as executive compensation, dividend payments, other capital sourcing and retention of bank holding company status. None of these are particularly onerous, but they must be taken into account by management.

Visit my next post to read about the very interesting Amendment clause that may represent an open-ended business portfolio risk management decision for the future.
 

Part 2

Reason one
Unfortunately, there is a management issue regarding their transparency with the investment community and/or client base.  Regrettably for the managers and leaders choosing this approach, if this problem persists too long, the organization may choose to rectify with a change in the management and leadership

Reason two
The solution is both simple and complex.  In simplistic terms, the financial institution must evolve its portfolio risk management reduction techniques and take a more proactive stance.  Both internal and external data exists that can provide significant insight to the portfolio, its trends and potential future loss. 

Such data sources include:

• Internal behavioral characteristics (negative changes outside of just delinquencies)
  • High line usage
  • Non sufficient funds frequency & severity (for those borrowers who also have a deposit account with the institution)
  • Deposit account closures
    
    External data
  • Regular rescore of the borrowers (both small business and consumer)
  • Derogatory payment trends with other creditors (the borrower may be current with you but for how long?)
  • Judgments or liens
     

Such data can be used to create models for portfolio performance calculating:

• Delinquency trends by score (as the portfolio trends up or down in the score ranges we can adjust the expected loss rates, delinquency rates, etc.)
• Within score ranges and based upon other behavioral characteristics, what is the likelihood for charge-off or recovery.

The biggest takeaway is that these portfolio management techniques are not new and untested.  Your data provider (such as Experian), has used these techniques and has the data to support the effectiveness.  While we are in trouble, we may find ourselves wanting to keep the “dirty secrets” to ourselves.  Too often such an approach leads to one’s demise.  Seek information, seek help, get control and truly start to move in a positive direction.
 

Stephanie Butler, manager of Process Architects, in Advisory Services at Baker Hill, a part of Experian continues from her last post by adding how to get back to the risk management basics.

With all that said, what is next?  You’ve learned the lessons and are ready to begin 2009 fresh.  How do you make sure that history does not repeat itself?  Simply get back to the basics by:

• Refocusing your lenders

The lenders are your first line of defense.  Make sure they understand the importance of accurate, complete information.  Through their incentives, hold them accountable for credit quality.  Retrain them, if necessary, on credit policy, financial analysis, business development, etc. 

• Creating or enhancing your loan review staff

A strong, internal loan review staff is crucial.  They are your second line of defense.  By sampling the entire portfolio on a regular basis, loan review can see trends that an individual loan officer cannot.  Loan review can aid in the portfolio management concentrations,  policy adherence and portfolio growth.  By reporting to either the holding company or credit administration, loan policy review can give an unbiased opinion on the quality of lending and the portfolio.

• Bring back the credit department and formally-trained credit analysts

For larger commercial loan underwriting requests, it is important to bring back the use of credit analysts and the credit department for in-depth financial analysis, loan write-ups and the discussion of strengths and weaknesses.  Don’t forget to train the credit analysts!  If you don’t feel you have the skill set within your institution for training, there are many good courses that your credit analysts can take.  Remember, this is your bench for future lenders.

• Bring accountability back

Everyone in your organization is accountable for a specific job or task.  You must hold your entire team, including senior management, accountable for their tasks, roles and the process of risk management. 

Remember, a lot of lessons were learned in 2008.  The key is not to waste this knowledge going forward.  Don’t keep doing what you have been doing!  Embrace the potential to improve your lending practices, financial risk management, training opportunities and customer satisfaction.  2009 is a new year!
 

This post is a feature from my colleague and guest blogger, Stephanie Butler, manager of Process Architects in Advisory Services at Baker Hill, a part of Experian.

Are you tired of the economic doom and gloom yet?  I am.  I’m not in denial about what is happening -- far from it.  But, we can wallow or move forward, and I chose to move forward.  Let’s look at a few of the many lessons that can be learned from the year and some action steps for the future.

1. Collateral does not make a bad loan good 
Remember this one? If you didn’t relearn this in 2008, you are in trouble.  Using real estate as collateral does not guarantee a loan will be paid back.  In small business/commercial lending, we should be looking at time in business, repayment trends and personal credit.  In consumer lending, time with an employer, time at the residence and net revolving burden are all key.  If these are weak, collateral will not make things all better.

2. Balance the loan portfolio 
Too much of a good thing is ultimately never a good thing.  First, we loaded our portfolios with real estate because real estate could never go bad.  Now, financial institutions are trying to diversify out of real estate and move into the “next great thing.”  Is it consumer credit cards, commercial C&I, or small business lines of credit?  It’s anyone’s guess.  The key is to balance the portfolio.  A balanced portfolio can help smooth the impact of economic trends and help managing uncertainty.  We all know that policy requires monitoring industry concentrations.  But, balancing the portfolio means more than that.  You also need to look at the product mix, collateral taken, loan size and customer location.  Are you too concentrated in unsecured lending?  How about lines of credit?  Are all of your customers in three zip codes?

3. Proactive vs. reactive
The days of using past dues for portfolio risk management are gone.  We need to understand our customers by using relationship management and looking for proactive markers to anticipate problems.  Whether this is done manually or through the use of technology, a process must be in place to gather data, analyze and anticipate loans that may need extra attention.  Proactive portfolio risk management can lessen potential charge-offs and allow the bank to renegotiate loans from a position of strength.

Be sure to check my next post as Stephanie continues with tips on how to get back to risk management basics.
 

Part 2

My colleague, Prince Varma, Senior Client Partner -- Portfolio Growth and Client Management, shares his advice on the best practices for portfolio risk management in these trying times.

Boy; this is an interesting time.

Banks today are at a critical threshold -- the biggest question that they are trying to answer is, "How do we continue to grow -- or at least avoid contracting -- without sacrificing profitability or credit quality?”
The urge to overcompensate, or engage in ultra conservative lending practices, must be resisted.  That said, we are already seeing a trend in which mid-sized and regional lenders are abandoning mid-tier credit.
This vacuum is being filled by community banks and credit unions which are implementing aggressive risk-based pricing programs in order to target the small business market.

These organizations are also introducing "safe and secure" campaigns that specifically target existing clients of banks in the news -- and attempting to entice those clients to switch over.

We are strongly urging banks to engage in an analysis of their existing portfolios in order to pinpoint opportunities for expanding their relationships with existing key clients.

Many senior executives are expressing apprehension about undertaking new projects given current levels of uncertainty.  Our best advice is two-fold.. First, focus on identifying those areas where process remediation will have long term and sustained value. Second, do not allow uncertainty to paralyze your internal improvement efforts.  Strong business cases lead to good decisions; don't let fear and apprehension cloud what you know needs to be done.
 

So here it is!  The moment you all have been waiting for--the top ten hot topics of 2009 (in no particular order of importance).

1. Portfolio Risk Management – You should really focus on this topic in 2009.  With many institutions already streamlining the origination process, portfolio management is the logical next step.  While the foundation is based in credit quality, portfolio management is not just for the credit side. 
2. Review of Data (aka “Getting Behind the Numbers”) – We are not talking about scorecard validation; that’s another subject.  This is more general.  Traditional commercial lending rarely maintains a sophisticated database on its clients.  Even when it does, traditional commercial lending rarely analyzes the data. 

3. Lowering Costs of Origination – Always a shoe-in for a goal in any year!  But how does an institution make meaningful and marked improvements in reducing its costs of origination? 

4. Scorecard Validation – Getting more specific with the review of data.  Discuss the basic components of the validation process and what your institution can do to best prepare itself for analyzing the results of a validation.  Whether it be an interim validation or a full-sized one, put together the right steps to ensure your institution derives the maximum benefit from its scorecard.

5. Turnaround Times (Response to Client) –Rebuild it.  Make the origination process better, stronger and faster.  No; we aren’t talking about bionics here -- nor how you can manipulate the metrics to report a faster turnaround time.  We are talking about what you can do from a loan applicant perspective to improve turnaround time.

6. Training – Where are all the training programs?  Send in all the training programs!  Worry, because they are not here.  (Replace training programs with clowns and we might have an oldies song.)  Can’t find the right people with the right talent in the marketplace? 

7. Application Volume/Marketing/Relationship Management – You can design and execute the most efficient origination and portfolio management processes.   But, without addressing client and application volume, what good are they?

8. Pricing/Yield on Portfolio – “We compete on service, not price.” We’ve heard this over and over again.  In reality, the sales side always resorts to price as the final differentiator.  Utilizing standardization and consistency can streamline your process and drive improved yields on your portfolio.

9. Management Metrics – How do I know that I am going in the right direction?  Strategize, implement, execute, measure and repeat.  Learn how to set your targets to provide meaningful bottom line results.

10. Operational Risk Management – Different from credit risk, operational risk and its management, operational risk management deals with what an institution should do to make sure it is not open to operational risk in the portfolio. Items totally in the control of the institution, if not executed properly, can cause significant loss.

Well, that’s it.  We encourage your feedback on this list.  Let us know which of these ten topics is a priority for your institution and what specific areas in each topic you would like to see addressed.

Part 2

To continue the discussion from my last post, we also must realize that the small business borrower typically doesn’t wait until we are ready to perform our regularly scheduled risk management review to begin to show problems.  While a delinquent payment is a definite sign of a problem with the borrower, the occurrence of a delinquent payment is often simply too late for any type of corrective action and will result in a high rate of loss or transfer to special assets.

There are additional pitfalls around the individual risk rating of the small business borrower or the small business loans; but, I won’t discuss those here.  Suffice to say, we can agree that the following holds true for portfolio risk management of small business loans:

• Active portfolio management is a must;
• Traditional commercial portfolio management techniques are not applicable due to the cost and effectiveness for the typical small business portfolio; and
• Collection efforts conducted at the time of a delinquency is too late in the process.

One last thing, the regulators are starting to place higher demands on financial institutions for the identification and management of risk in the small business portfolio.  It is becoming urgent and necessary to take a different approach to monitor that portfolio.

Just as we have learned from the consumer approach for originating the loans, we can also learn from the basic techniques used for consumer loan portfolio risk management.

We have to rely upon information that is readily available and does not require the involvement of the borrower to provide such information.  Basically, this means that we need to gather information (such as updated business scores and behavioral data) from our loan accounting platforms to provide us with an indication of potential problems.  We need to do that in an automated fashion.  From such information we can begin to monitor:

• Changes in the business score of the small business borrower;
• Frequency and severity of delinquencies;
• Balances maintained on a line of credit; and
• Changes in deposit balances or activity including overdraft activity.
  

This list is not exhaustive, but it represents a solid body of information that is both readily available and useful in determining the risk present in our small business portfolio.  With technology enabling a more automated assessment of these factors, we have laid the groundwork to develop an efficient and effective approach to small business portfolio management.  Such an approach provides real- time regular assessment of the portfolio, its overall composition and the necessary components needed to identify the potential problem credits within the portfolio.

It is past time to take a new approach toward the proactive portfolio management of our small business loan portfolio retaining the spirit of commercial credit while adapting the techniques of consumer portfolio management to the small business portfolio.

Part 1

In reality, we are always facing potential issues in our small business portfolio, it is just the nature of that particular beast. Real problems occur, though, when we begin to take the attitude that nothing can go wrong, that we have finally found the magic formula that has created the invincible portfolio.  We’re in trouble when we actually believe that we have the perfect origination machine to generate a portfolio that has a constant and acceptable delinquency and charge-off performance.
 
So, we all can agree that we need to keep a watchful eye on the small business portfolio.  But how do we do this?  How do we monitor a portfolio that has a high number of accounts but a relatively low dollar amount in actual outstandings? 

The traditional commercial portfolio provides sufficient operating income and poses enough individual client credit risk that we can take the same approach on each individual credit and still maintain an acceptable level of profitability.  But, the small business portfolio doesn’t generate sufficient profitability nor has individual loan risk to utilize the traditional commercial loan portfolio risk management techniques.
 
Facing these economic constraints, the typical approach is to simply monitor by delinquency and address the problems as they arise.  One traditional method that is typically retained is the annual maturity of the lines of credit.  Because of loan matures, financial institutions are performing annual renewals and re-underwriting these lines of credit -- and complete that process through a full re-documentation of the line. 

We make nominal improvements in the process by changing the maturity dates of the lines from one year to two or three year maturities or, in the case of real estate secured lines, a five year maturity.  While such an approach reduces the number of renewals that must be performed in a particular year, it does not change the basic methodology of portfolio risk management, regularly scheduled reviews of the lines.  In addition, such methodology simply puts us back to the use of collections to actually manage the portfolio and only serves to extend the time between reviews.

Visit my next post for the additional pitfalls around individual risk rating and ways to better monitor your small business portfolio.

In previous posts, we’ve dealt with the role of risk-based capital, measuring performance based on risk characteristics and the need for risk-based loan pricing. What about risk mitigation? Some of the greatest sins of the financial industry in the current malaise have been the lack of transparency, use of complex transactions to transfer risk and the creation of off-balance-sheet entities to house dodgy investments.

Much has been made of the role of Credit Default Swaps (CDSS) as one of the unregulated markets (and therefore guilty parts) of the current credit meltdown. The regulatory agencies and the media are aghast at the volume (peak of some $62 trillion in notional value) of CDSS that have resulted from a totally private market. The likes of Lehman Brothers, Bear Sterns and AIG were all big issuers of CDSS. And the trillions of notional value of open CDSS is as much as 100 times the underlying value of the actual debt being insured.

There are problems here, but it may be worth clarifying the useful risk management activities from the potentially abusive excesses involving such instruments.

CDSS are derivative contracts whereby one party buys credit protection from a counterparty. The buyer pays a premium to the seller either in a lump sum or periodically over the life of the contract. If a credit event such as a default on a loan or a bond occurs, the seller of the CDSS pays the holder for the loss or purchases the initial debt, the reference obligation, at a pre-set price.  So, a CDSS is in effect a put option that is deep-out-of-the-money. They expire upon termination and most are never exercised. They are subject to fair-value accounting and can change in value from month to month as the credit markets premiums for similar cover moves up or down.

Banks and others can use CDSS to, in effect, adjust the nature of credit risk in their portfolios by both buying and selling such contracts.

Asset securitizations, whether mortgage-backed securities or other formulations, are in fact broken-down and re-packaged forms of assets that can be sold -- transferring certain rights, values and risk to another party for payment received. They are complex and therefore mostly opaque to the general public and even many practitioners. They often involve the use of special purpose entities or trusts that can further confuse investors. These tactics have added to the difficulty of the credit crisis and the collapse of capital markets.

But, CDSS are contingent in nature and act more like fire insurance or a back-up data center. Such operational expenses are intended to control risks. The accounting treatment is complex and, to an extent (especially as regards the tax treatment), still not well defined by accounting authorities. For most banks, and most CDSS contract, the premium is amortized over the life of the contract. The premium expense entry in their general ledgers is an expense of doing business that is intended to alleviate some credit risk. We are now talking about a covered CDSS, where the bank has extended credit or invested in a debt instrument. Those who purchased uncovered CDSS are gambling on a default occurrence and used CDSS as a more cost-effective (and secretive) alternative to shorting securities. It is somewhat like a naked short.

So, a covered CDSS is ultimately an expense associated with protecting the net asset value of a credit transaction. Importantly, this expense should be included in any performance analysis or pricing of the risk-adjusted profitability of the credit obligation and/or client relationship involved. This risk mitigation exercise may be in lieu of a higher required rate or fee on an otherwise uncovered/unmitigated credit transaction, or being satisfied with a lower risk-adjusted return where the bank assumes (self-insures) all of the credit risk.

CDSS quotes/costs, similar to rate spreads on corporate bonds, are the open market’s current feeling regarding an entity’s credit quality or relative probability of default. There are some 400 or so participants in the CDSS market, including writers and dealers. Market data is published for many obligations. Even the previously risk-free Treasury securities now have CDSS quotes – and they have gone up considerably in recent months. It is always the buyers’ responsibility to decide if the quoted prices make sense or not and how such quotes should be used in evaluating credit and negotiating lending opportunities in addition to whether or not to purchase this insurance.

Finally, the quality of the seller is a consideration. There is no good reason to buy fire insurance from someone that might not be able to pay for your building if it burns down. CDSS have been private party transactions and, as stated earlier, there have been solvency problems with some of the sellers of such instruments. There is now a move under way to create a central exchange for such transactions with both regulations governing the sellers, more standardized contracts and financial backing of the instruments from the exchange. Such an exchange will address both the transparency of the process and the efficiency of market prices.

Risk mitigation strategies (risk-based pricing, portfolio risk management, credit risk modeling, etc.) need to be carried out thoughtfully. If something sounds too good to be true, it deserves a deeper look. Your bank’s credit regimen may well be better at evaluating default probability than a marketplace that is prone to feed on its own fears. But, CDSS “insurance” quotes are an outside point of reference and an option to mitigate some credit risk…no pun intended.

Here are two interesting sources of information:

*  BNET Business Network

* Georgetown University -- Law Center

Just as with diet recommendations, moderation needs to be the new motto for credit risk management.  Diets provide for the occasional bag of chips or dessert after dinner, but these same food items become problems if the small quantity or occasional indulgence suddenly becomes the norm. 

Similarly, we, in our risk management efforts, put forth guidelines that establish limitations on certain loan types or categories that have been deemed risky should the numbers or quantity become too large a part of the overall portfolio.  Unfortunately, we have a tendency to allow earnings or portfolio growth to cloud our judgment and take an attitude of “just one more.” 

In the past several years, we have experienced excesses in commercial real estate, residential development and subprime mortgages.  It is now these excesses that are creating the problems that we are dealing with today. 

Bringing back these limitations – in other words, reestablishing the discipline in our portfolio risk management – will go a long way in avoiding these same problems in the future. 

As I learned early in my banking career:  “…soundness, profitability and growth…in that order.”

We know that financial institutions are tightening their credit standards for lending.  But we don’t necessarily know exactly how financial institutions are addressing portfolio risk management -- how they are going about tightening those standards. 

As a commercial lender, when the economy was performing well, I found it much easier to get a loan request approved even if it did not meet typical standards.  I just needed to provide an explanation as to why a company’s financial performance was sub-par and what changes the company had made to address that performance -- and my deal was approved. 

When the economy started to decline, standards were suddenly elevated and it became much more difficult to get deals approved.  For example, in good times, credits with a 1.1:1 debt service coverage could be approved; when times got tough – and that 1.1:1 was no longer acceptable – the coverage had to be 1.25:1 or higher. 

Let’s consider this logic.  When times are good, we loosen our standards and allow poorer performing businesses’ loan requests to be approved…and when times are bad we require our clients perform at much higher standards.  Does this make sense?  Obviously not.  The reality is that when the economy is performing well, we should hold our borrowers to higher standards.  When times are worse, more leniency in standards may be appropriate, keeping in mind, of course, appropriate risk management measures.

As we tighten our credit belts, let’s not choke out our potentially good customers.  In the same respect, once times are good, let’s not get so loose regarding our standards that we let in weak credits that we know will be a problem when the economy goes south.