Decision Analytics | Relationship Management

Hello. My name is Prince Varma and I’ve spent the better part of the last 16 years helping financial institutions (FI) successfully improve their in business development, portfolio growth and client relationship management practices.

So, since the focus of this blog is to speak to readers about risk management, many of you are probably wondering what a “sales and business development” guy is doing writing a piece related to mitigating and managing risk?

Great question!

The simple fact is that the traditional or prevailing sentiment or definition related to risk management – mitigating credit risk -- is incomplete. A more accurate and comprehensive approach would be to recognize, acknowledge and address that “risk” cuts across the entire client relationship spectrum of:

• client penetration/growth;
• client retention; and
• client credit risk mitigation.

How do penetration and retention count as “risk factors”?
(this is where the sales guy stuff comes in)

From a penetration perspective, the failure to recognize potential opportunities either within the existing client base or in the operating market, introduces revenue growth risk (meaning we aren’t keeping our eye on the top line). Ultimately it impacts the FI’s ability to add assets (either deposits or loans) and also has a direct affect on efficiency and deposit to loan ratios.

From a retention perspective, the risk is even more obvious. Our most valued clients are the ones that we must continuously engage in a proactive manner. Let’s face it. In even the smallest markets, there are no less than four to six other institutions waiting to jump on your client in the event that you grow complacent. There is a huge difference between selection and satisfaction. And, if we aren’t focused on keeping a client after securing them, our net portfolio growth targets will be impossible to achieve. 

Considering the current market environment, now more than ever, effectively managing these three elements of “risk/exposure to the FI” is crucial to an institutions success both practically and pragmatically. Everyone internally at the bank is focused on the “credit risk mitigation” piece. The conversations that are occurring outside of the bank’s walls however are focused on the “L” word or liquidity and getting credit flowing again.

How many times have we read or more frankly been beaten with this comment from business owners “…there’s no one making loans anymore…” or “…its impossible to get credit…?”

That should be read as … penetration and retention

Striking a balance between effective and appropriate credit risk exposure and deepening or growing the portfolio has been a challenge facing those of us in the front office for as long as I can remember. The “sales revolution” is effectively over. We’ve learned the critical lesson that we need to evolve beyond being strictly a credit officer (you did learn that right??!!). And, you didn’t/shouldn’t become a “banking products generalist” with no analytical depth. Knowing all this, it is important that we return to the guiding principles of effective lending which include:
- evaluating the scope of the opportunity;
- isolating the risk and identifying a reasonable and realistic recovery/mitigation remedy;
- determining what other alternatives the borrower might be considering; and
- being willing to let the “bad deals” walk.

In subsequent blogs, I’ll provide you with specific tactics aimed at optimizing penetration and retention efforts and implementing effective and practical client management strategies.

After all what would you expect from a business development guy…
 

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

Years ago, I attended a seminar at which the presenter made a statement that struck me as odd, but has proven to be quite prophetic.  He simply stated, “margins will continue to narrow … forever!” He was spot on.
At that time, a variety of loan products (such as mortgage loans) were becoming commoditized and this emerging market acted as an intermediary for needed cash to provide banks the wherewithal to continue to lend in their respective locales. The presenter continued by making a call for a systematic and effective pricing methodology then and “forever”.
Pricing loans in a competitive market does not necessarily translate into smaller yields. Nor should banks be willing to accept smaller yields for less than quality loans. There are several viable options to consider when loan pricing in a market where the margins continue to shrink.

Cutting operating expenses
Generally, a financial institution’s first reaction to narrowing margins is to cut operating expenses. Periodically the chaff does need culling, but most banks run efficient shops by depending heavily on technology to create those efficiencies and for risk management. They continually measure themselves with efficiency ratios which, in part, help to drive their strategic operating decisions. So, when the edict comes from above to cut operating expenses, there aren’t too many options.

So, why is a bank’s first reaction usually an all-out call to cut operating expenses? Generally, it’s because these operating expenses are more easily identifiable and banks still lack effective tools to measure the value of their customers and relationships. Couple that with the perception that there is no control over a competitive market with narrowing margins. As a result, banks price accordingly -- just to get the deal. Consequently, their efficiency ratios may look good, but what about the potential impact on yield, service and internal morale? Community banks, in particular, pride themselves on customer service and, in fact, site it as one of their strengths against larger banks. Do you give up that advantage?

Relationship management
To price effectively in a market where margins have narrowed, the bank has to also consider the relationship’s value. The value of deposits should be measured and included to allow for more competitive pricing. The influence of deposits on the relationship allows the bank to be more aggressive in its loan pricing or can enhance the relationship yield itself.
Loan pricing in a competitive market does not have to translate into smaller yields and/or credit quality. The key to staying ahead of competition is measuring the value of the relationship and applying any or all of the outlined effective risk-based pricing methodologies to position the bank to win the deal and still meet the targeted return objectives. While the phrase “margins will continue to narrow … forever” may seem to hold true, banks can counter by using the “power of pricing” to offset the impact to earnings …forever!
 

The debate continues in the banking industry -- Do we push the loan authority to the field or do we centralize it (particularly when we are talking about small business loans)?

A common argument for sending the loan underwriting authority to the field is the improved turnaround time for the applicant. However, reality is that centralized loan authority actually provides a credit decisioning time almost two times faster than those of a decentralized nature.  The statistics supporting this fact are from the Small Business Benchmark Study created and published by Baker Hill, a Part of Experian, for the past five years.

Based upon the 2008 Small Business Benchmark Study, those financial institutions with assets of $20 billion to $100 billion used only centralized underwriting and provided decisions within 2.5 days on average. In contrast, the next closest category ($2 billion to $20 billion in assets) took 4.4 days.

Now, if we only consider the time it takes for decisioning (meaning we have all the information needed), the same disparity exists.  The largest banks using solely centralized underwriting took 0.8 days to make a decision, while the next tier ($2 billion to $20 billion) took an average 1.5 days to make a decision.  This drop in centralized underwriting usage between these two tiers was simply a 15 percent change. This means that the $20 billion to $100 billion banks had 100% usage of centralized underwriting while the $2 billion to $20 billion dropped only to 85% usage. Eighty-five percent is still a strong usage percentage, but it has a significant impact on underwriting turnaround time.

The most perplexing issue is that the smaller community banks are consistently telling me that they feel their competitive advantages are that they can respond faster, have consistent account management and they have better relationship management practices than bigger, impersonal banks.  Based upon the stats, I am not seeing this competitive advantage supported by reality.  What is particularly confusing is that the small community banks, that are supposed to have better relationship management, take twice as long overall from application receipt to decision and almost three times as long when you compare them to the $20 billion to $100 billion category (0.8 days) to the $500 million to $2 billion category (2.2 days).

As you can see - centralized loan underwriting processes work.  They are consistent, provide improved customer service, improve throughput, increase efficiency and improve credit quality when compared to the decentralized underwriting approach. 

In future blogs, I will address the credit quality component of loan underwriting processes.
 

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 1

In my last three posts, we have covered the key parts of how risk-based loan pricing works. We have discussed how the key foundational elements involved in risk-adjusted loan pricing can and should relate to the bank’s accounting results and strategic policies. We went from the pricing analysis of an individual loan on a risk-adjusted basis to solving for a bank-wide target or guideline return. We also mentioned how this analysis can be expanded to the client relationship level, both producing a relationship management view of any existing loans and the impact of pricing a renewal or new credit to impact the client-level return. Finally, I mentioned that although this capability can exist (and does in more banks than ever before), it isn’t an easy undertaking in an industry that is historically keyed to volume goals rather than transaction profit (let alone risk-adjusted profit).

So, why go through the effort? Moving to a risk-adjusted view of lending and relationship management requires serious thought, effort and resolve. It involves change and teaching lenders a new trick. It even suggests that the lending executive (perhaps the next president of the bank) hasn’t been doing the best job possible to protect and advance the bank’s margins. Any new undertaking involves management risk. And, accurate or not, bank executives are not generally viewed as terrific change agents. Is this concept of risk-based pricing worth all the time and trouble? We think so – for two general reasons.

Corporate governance
Almost any business, if not any undertaking of any kind, involves risk to some degree. Finance in general, and commercial banking, specifically, involves several kinds of risk. The most obvious risk is repayment or credit risk. Banks have been lending money successfully for a long time. The funny thing is that often, when we’ve studied the actual loan rates of a bank’s portfolio versus the bank’s own risk ratings (or risk grades), we see almost no difference in loan pricing. The banks have credit policies that discuss the different ratings in some detail. And, the banks usually have some sort of provisioning process or ALLL (Allowance for Loan and Lease Losses) logic that uses these differences in risk rating. Loan review guidelines often use the differences in risk rating to gauge the review frequency and depth.

So, the banks know what’s going on. They know that a higher risk borrower/loan is less likely to be repaid in full than a lower credit risk borrower/loan. But, the lending operation goes on as if they were all about the same. There seems to be a disconnect (kind of like when my arms and brain disconnect when I swing a golf club). I know if I slow down I’ll hit a better shot, but I still swing way too fast. It seems to me that since the bank has all of these terrific policies in place dealing with credit risk, that good governance would require that credit risk be reflected more fully when loans are marketed, negotiated and agreed to – rather than just when they go awry.

I would make the same general argument for management consistency associated with other risk types. If the loan duration is longer, good governance would reflect (pay for) a realistic marginal funding cost of the same duration. This would help to align the loan pricing effort with the guidelines or policies associated with ALCO or Asset and Liability Policy Committee and Interest Rate Risk (IRR) management. If a loan involves higher or lower risk of unexpected loss based on loan/collateral type and risk rating, then the risk capital associated with the loan should vary accordingly. The risk-based allocation of capital will then require different pricing in order for the loan to hit a targeted return. This protection of return, on a risk-adjusted basis, is the final step in good governance – in this case, to protect the shareholders specific contribution (of their equity) to funding the loan in question.

Finally, if I were a director, regulator or an auditor (again), and I reviewed all of these fine policies related to risk management, and did not see them reflected in deal pricing, I would have to ask “why?”.  It would seem that either executive management doesn’t really believe in their own policies, or they are willing to set them aside when negotiating deals for the added business. Maybe loan management doesn’t want to be bothered by the policies while they’re out there in the “real world” fighting for added loan volume. Either way, there seems to be a governance disconnect. Which I know on the golf course, leads to lost balls and unnecessary poor scores.

My second major reason will follow in my next blog.

Part 2

To continue from my previous post discussion, we will now expand the concept of risk adjusted loan pricing to the relationship management level. If we can calculate risk-based returns for individual loans (either exiting credits or proposed renewals/additions), it isn’t too difficult to add them up for a client’s overall profitability picture. Using a similar approach as in my last post, the lender can see the impact of the simulated changes to a new loan on the risk-adjusted return at the client relationship level. It doesn’t have to be a new loan and may just be a renewal/rollover of an expiring line or maturing loan. After all, most of the banks sales in a given period come from existing business.

Let’s look at a quick example.
The bank’s goal is 12% ROE. My client, with their existing loans is at 11% ROE. I’d like to move them higher and definitely not see them decline. I want to use the pricing calculator to look at a renewal of one of their lines that involves about 25% of their outstanding balances. I run a solution on the renewal that produces a risk-adjusted 12% ROE on the renewed loan. I also find that this brings the relationship up to 11.25% ROE. I try some added runs on the renewed credit to see if  I can come up with a structure that gets me over 12% ROE on the loan (and over 11.25% on the relationship), that I think I can sell. I have a couple of options to pursue including one with a fixed rate for the next year, and one that is a floating rate. They each have differing fee amounts, but, they both have a risk-based return that I believe my boss and the loan committee would go along with. I now know where I want to try to end the negotiations with my client. It’s up to me to create the right discussion posture and close the deal.

There’s nothing automatic about this.
It takes a lot of education and effort to succeed and the targets may not be achieved instantly. Do not confuse the benefits of the overall direction (of risk-based performance measurement) with the behavioral adaptation that needs to take place in daily lending practices. Along with the creation of the risk-based pricing and profitability functionality, there needs to be a significant educational investment for management and staff. A risk-based and profit-based lending function isn’t the way banking has been done for most industry participants – ever. This is still new to most of us. So, the explanation, reinforcement and adaptation to the concept will take time and effort. And, it will take a huge quantity of executive resolve.

I’m not finished with this topic. We still have a lot to discuss including deposit profitability and how profitable risk-based pricing and banking can be. So, I’ll continue to come back to this topic in future posts. 
 

Part 1

Risk-based pricing starts as a product-level reflection of a bank’s financial and risk characteristics. In my last few posts we have covered the key parts of how risk-based loan pricing works. In doing so, we have discussed how the key foundation elements involved in risk-adjusted loan pricing can (and should) relate to the bank’s accounting results and strategic policies:

• Loan balance, rate and fee data relates to the bank’s actual general ledger amounts;
• The administrative costs are also derived from actual non-interest expenses; 
• The cost of funds is aligned with the policies used in the ALCO operation and in the IRR management processes; 
• The statistical cost of credit risk used in pricing (providing sensitivity to the loan’s risk rating) is derived partially from the bank’s credit and provisioning policies;
• The taxes are the bank’s actual average experience; and 
• For banks using ROE/RAROC, the equity allocation is related to the bank’s overall (unexpected) risk posture and its capital sufficiency policies.

Once a bank understands risk-adjusted pricing and can calculate the risk-adjusted return (ROA or ROE/RAROC) for a given loan, what more can we do to help the lender close the deal? And, what can we do to help lenders assist the bank with meeting profit goals? The answer to both questions is: “quite a lot”. First, bank management and lending executives can set various risk-based goals or guidelines that are based on the same data and foundation logic that was used to create the risk-based profit calculations. This analytical form of targeting helps take the profit (and therefore pricing) process out of the realm of “blue sky” numbers or simply wishful thinking on the part of management. The risk-based targeting guidelines benefit from the same analytical processes that went into the logic behind creating the profit calculations. The targets should be as well-founded as the analysis that went into the profit calculations.

Then the fun begins.
First at the loan level: Once we have the ability to calculate risk-adjusted loan profit and we have similarly founded targets or guidelines, we can easily use the profit calculations in reverse to solve for a required loan rate and/or origination fee that will meet the target profit. The lender can change a structural aspect of the loan under consideration and quickly see the impact on risk-adjusted profit. More importantly, they can see how these changes relate to the guidelines or target.

In fact, the lender could look at any number of changes to the loan amount, tenor, amortization rate, moving the risk rating up or down, and changing the rate from fixed to floating impact to see what relative impact the change has on risk-adjusted profit. Because knowledge is one key to successful negotiation, the lender is in a substantially stronger position to conduct the sales and negotiation phases of landing the deal. There is a substantially higher likelihood the resulting loan will be a better risk-adjusted return for the bank than would take place by ignoring such pricing practices. Add up all of the loan and lines done in the course of a year and you see a significant impact on the bank’s overall performance.

In my next post, I’ll expand this concept to the relationship management level.

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.

I’m speculating a bit here, but I have a feeling that as the first wave of Red Flag rule examinations occurs, one of the potential perceived weak points in your program(s) may be your vendor relationships.  Of particular note are collections agencies.  Per the guidelines, “Section 114 applies to financial institutions and creditors.” Under the FCRA, the term “creditor” has the same meaning as in section 702 of the Equal Credit Opportunity Act (ECOA), 15 U.S.C. 1691a.15 ECOA defines “creditor” to include a person who arranges for the extension, renewal or continuation of credit, which in some cases could include third-party debt collectors.  Therefore, the Agencies are not excluding third-party debt collectors from the scope of the final rules and “a financial institution or creditor is ultimately responsible for complying with the final rules and guidelines even if it outsources an activity to a third-party service provider.”

A general rule of thumb in any examination process is to look closely at activities that are the most difficult for the examinee to control.  Third-party relationship management certainly falls into this category.  So, make sure your written and operational programs have procedures in place to ensure and regularly monitor appropriate Red Flag compliance -- even when customer (or potential customer) activities occur outside your walls.

Good luck!

Part 2

Return on Equity (ROE)
ROE is the risk-adjusted profit divided by the equity amount associated with the loan in question.

ROE =      Risk-adjusted profit
                Equity amount of the loan

There are two large advantages to using ROE. One, you can use it to compare profit performance across asset-based and non-asset-based products. This can’t be done with ROA – if there’s no “A”, you can’t create the ratio. This seems to be a crucial consideration if you are serious about cross-selling non-asset-based products (such as deposits and a long list of non-credit financial services) and if you are serious about being a truly client relationship oriented organization.

Second, by using ROE you have the possibility of risk-adjusting the amount of equity used in the denominator of the calculation.  Adjusting the equity amount based on risk, in a credible manner, creates risk-adjusted ROE, or what is referred to as risk adjusted return on capital (RAROC). The equity amount applied to the loan represents all of the remaining risk or unexpected loss (UL).instance that we did not account for in the steps that got us to the risk-adjusted profit result. RAROC, or risk-adjusted ROE, is a fully risk-adjusted representation of relative value. This level of risk-based performance measurement also has the advantage of relating pricing and relationship management activities to the bank’scapital management process.

So far, we have covered several of the key parts of how risk-based pricing can work. In doing so, we have discussed how the various elements involved in pricing relate to the bank’s books and policies. The loan balance, rate and fee data relates to the banks actual general ledger amounts. The administrative costs are also derived from actual non-interest expenses. The cost of funds is aligned with the policies used in ALSO and in IRR management processes. The cost of credit risk is related to the bank’s credit and provisioning policies. The taxes are the bank’s actual average experience. And, for banks using ROE/RAROC, the equity allocation is related to the bank’s overall risk posture and its capital sufficiency policies.

I stated earlier that “Risk-based pricing analysis is a product-level microcosm of risk-based bank performance”. It is that and more. In addition to pricing’s linkage to financial figures and results, risk-based pricing should also be a reflection of the bank’s most critical risk management policies and governance processes.

I have referred to risk-adjusted commercial loan pricing (or the lack of it) in previous posts. At times, I’ve commented on aspects of risk-based pricing and risk-based bank performance measurement, but I haven’t discussed what risk-based pricing is -- in a comprehensive manner. Perhaps I can begin to do that now and in my next posts.

Risk-based pricing analysis is a product-level microcosm of risk-based bank performance. It begins by looking at the financial implications of a product sale from a cost accounting perspective. This means calculating the revenues associated with a loan, including the interest income and any fee-based income.  These revenues need to be spread over the life of the loan, while taking into account the amortization characteristics of the balance (or average usage for a line of credit). To save effort (and to provide good client relationship management), we often download the balance and rate information for existing loans from a bank’s loan accounting system.

To “risk-adjust” the interest income, you need to apply a cost of funds that has the same implied market risk characteristics as the loan balance. This is not like the bank’s actual cost of funds for several reasons. Most importantly, there is usually no automatic risk-based matching between the manner in which the bank makes loans and the term characteristics of its deposits and/or borrowing. Once we establish a cost of funds approach that removes interest rate risk from the loan, we subtract the risk-adjusted interest expense from the revenues to arrive at risk-adjusted net interest income, or our risk-adjusted gross margin. 

We then subtract two types of costs. One cost includes the administrative or overhead expenses associated with the product. Our best practice is to derive an approach to operating expense breakdowns that takes into account all of the bank’s non-interest expenses. This is a “full absorption” method of cost accounting. We want to know the marginal cost of doing business, but if we just apply the marginal cost to all loans, a large portion of real-life expenses won’t be covered by resulting pricing. As a result, the bank’s profits may suffer. 

We fully understand the argument for marginal cost coverage, but have seen the unfortunate end. Using this lower cost factor can hurt a bank’s bottom line. Administrative cost does not normally require additional risk adjustment, as any risk-based operational expenses and costs of mitigating operation risk are already included in the bank’s general ledger for non-interest expenses. 

The second expense subtracted from net interest income is credit risk cost. This is not the same as the bank’s provision expense, and is certainly not the same as the loss provision in any one accounting period.  The credit risk cost for pricing purposes should be risk adjusted based on both product type (usually loan collateral category) and the bank’s risk rating for the loan in question. This metric will calculate the relative probability of default for the borrower combined with the loss given default for the loan type in question. 

We usually annualize the expected loss numbers by taking into account a multi-year history and a one- or two-year projection of net loan losses. These losses are broken down by loan type and risk rating based on the bank’s actual distribution of loan balances. 

The risk costs by risk rating are then created using an up-sloping curve that is similar in shape to an industry default experience curve. This assures a realistic differentiation of losses by risk rating. Many banks have loss curves that are too flat in nature, resulting in little or no price differentiation based on credit quality. This leads to poor risk-based performance metrics and, ultimately, to poor overall financial performance. The loss expense curves are fine-tuned so that over a period of years the total credit risk costs, when applied to the entire portfolio, should cover the average annual expected loss experience of the bank. 

By subtracting the operating expenses and credit risk loss from risk-adjusted net interest income, we arrive at risk-adjusted pre-tax income. In my next post I’ll expand this discussion further to risk-adjusted net income, capital allocation for unexpected loss and profit ratio considerations.