Risk Management

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.
 

“Unprecedented times,” “financial crisis,” “credit crisis” and many other terms continue to be buzzwords that we hear every day.  We are almost becoming desensitized to the terms, yet we feel the impact on a daily basis.  Everyone is waiting for some positive news in the financial services industry and more bad news keeps coming.

Each quarter we continue to read about financial institutions claiming that the worst is over. They have recognized the risk in their portfolios through risk assessment, set aside adequate reserves or loan loss allowances and are now ready to turn the corner.  Yet we continue to read about these same institutions coming back with more bad news, more credit losses and a restatement of the assurance that the problems have been recognized. As a result, this financial risk management has brought to light all of the high-risk accounts and the trend will begin to change.

Why does this story keep repeating itself? 

Reason one 
Management assesses to what extent the market (both stock market and the client base) will tolerate the level or degree of bad news, recognize losses to that extent and will then work hard to try to correct any known issues before we actually have to report the next quarter.  Unfortunately, this approach simply delays the inevitable and brings into question the risk management practices of the particular institution.  Like the boy who cried wolf, the more times you make a statement and it proves to be false, the less likely you will be believed the next time. 

Reason two
The financial institutions are actually surprised each quarter with a new batch of credit losses.  The institution, its credit management team and workout areas are diligently trying to address the current problem. But, just when they start to see the light at the end of the tunnel, a new batch of credit problems arise.  For the most part, the credit issues still persist in the high-volume, low-dollar credits such as residential mortgages, home equity loans, automobiles, credit cards and small business loans.  Due to the sheer volume of clients/loans, it becomes more difficult to assess what issues may be brewing in the portfolio.  For the large volume, small dollar portfolios, the notion of a pending credit issue comes when the delinquency starts to rise to a delinquency of 60 or 90 days. The real issue is identifying those accounts that are likely to go 60 or 90 days past due and then assess the likelihood that they will go into charge-off.

Regardless of the reason, we have a “credibility” problem in addition to a “credit” problem.
 

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.
 

Part 1

Many banks are scrambling to determine how best to address credit issues in their portfolios.  It seems that, when one fire gets put out, there is another one right behind it.  Best practice dictates that a financial institution should not simply try to review the entire portfolio to assess which borrowers are in trouble, which ones have the potential for problems and which ones are okay.  This traditional approach takes too much time and it diverts resources to an exercise that does not produce objective, timely identification of problems (that either exist currently or may start to develop in the near future).
 
I recommend that financial institutions systematically identify looming risks in a portfolio -- and take swift and appropriate action to mitigate and manage those risks.  While you may not be able to eliminate risk, you can definitely minimize it and deploy risk management solutions.

Don’t panic.  We tend to make poor decisions when we are in panic mode. There are still good loans out there.  Unfortunately – and fortunately – there seem to be problem loans everywhere we turn.  Unfortunately, we have to bear the expense of related charge-offs.  Fortunately, though, we can learn from – and benefit from – what happened to these problem loans.  This demands examination of the data.  Analyze what went wrong. 
Identify which loans are still performing and seek out more of those types of credits.  Don’t shut down the production.  From a pure statistics viewpoint, you are only accentuating the problem.  When you stop feeding the portfolio with new loans (and given the typical run-off of a portfolio), your past dues and charge-offs actually trend worse.  In each case, the denominator in the formula is the total portfolio dollars outstanding.  As you shrink the portfolio, by significantly reducing the loan production, you are actually decreasing the number by which you are comparing your problem loans.  Basically, you are letting the good loans run-off while you are left with the bad.

Look for industries that are still performing well in these economic times.  There are counter-cyclical industries that do well in poor economic conditions.

Get aggressive about identifying potential problems early.  This is done through regular rescoring of your loan portfolio and watching for negative behaviors.  Early intervention means a potential reduction in actual loss (if the loss in inevitable).

Be careful that you do not get too aggressive and start to push away good business.  Even good accounts (that you would seek out in good times) may experience occasional problems – don’t drive them off.

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.

We have talked about: the creation of the vision for our loan portfolios (current state versus future state) – e.g. the strategy for moving our current portfolio to the future vision. Now comes the time for execution of that strategy.

In changing portfolio composition and improving credit quality, the discipline of credit must be strong (this includes in the arenas of commercial loan origination, loan portfolio monitoring, and credit risk modeling of course). Consistency, especially, in the application of policy is key. Early on in the change/execution process there will be strong pressure to revert back to the old ways and stay in a familiar comfort zone.  Credit criteria/underwriting guidelines will have indeed changed in the strategy execution.

In the coming blogs we will be discussing:

• assessment of the current state in your loan portfolio;
• development of the specific strategy to effect change in the portfolio from a credit quality perspective and composition;
• business development efforts to affect change in the portfolio composition; and
• policy changes to support the strategy/vision.

More to come.

In my last blog, I talked about the overall need for a vision for your loan portfolio and the similarity of a loan portfolio to that of an investment portfolio.  Now that we have that vision in place, we can focus on the overall strategy to achieve that vision. 

A valuable first step in managing an investment portfolio is to establish a targeted value by a certain time (say, our targeted retirement age).  Similarly, it’s important that we establish our vision for the loan portfolio regarding overall diversification, return and risk levels.

The next step is to create a strategy to achieve the targeted state.  By focusing on the gaps between our current state and the vision state we have created, we can develop an action plan for achieving the future/vision state.  I am going to introduce some rather unique ideas here. 

Consider which of your portfolio segments are overweight?  One that comes to mind would be the commercial real estate portfolio.  The binge that has taken place over the past five plus years has resulted in an unhealthy concentration of loans in the commercial real estate segment.  In this one area alone, we will face the greatest challenge of right-sizing our portfolio mix and achieving the appropriate risk model per our vision. 

We have to assess our overall credit risk in the portfolios next.  For small business and consumer portfolios, this is relatively easy using the various credit scores that are available to assess the current risk.  For the larger commercial and industrial portfolios and the commercial real estate portfolios, we must employ some more manual processes to assess risk.  Unfortunately, we have to perform appropriate risk assessments (current up-to-date risk assessments) in order to move on to the next stage of this overall process (which is to execute on the strategy).

Once we have the dollar amounts of either growth or divestiture in various portfolio segments, we can employ the risk assessment to determine the appropriate execution of either growth or divestiture.

Stick with me on this topic because in my next blog we will discuss appropriate risk assessment methodologies and determine appropriate portfolio distributions/segmentations.

It is the time of year during which budgets are either in the works or have been completed.  Typically, when preparing budgets, we project overall growth in our loan portfolios…maybe.  Recently we conducted an informal survey, the results of which indicate that loan portfolio growth is still a major target for 2009.  But when asked what specific areas in the loan portfolio -- or how loan pricing and profitability -- will drive that growth, there was little in the way of specifics available.  This lack of direction (better put, vision) is a big problem in credit risk management today.

We have to remember that our loan portfolio is the biggest investment vehicle that we have as a financial institution.  Yes; it is an investment.  We choose not to invest in treasuries or fed funds -- and to invest in loan balances instead -- because loan balances provide a better return.  We have to appropriately assess the risk in each individual credit relationship; but, when it comes down to the basics, when we choose to make a loan, it is our way of investing our depositors’ money and our capital in order to make a profit.

When you compare lending practices of the past to that of well-tested investment techniques, we can see that we have done a poor job with our investment management.  Remember the basics of investing, namely: diversification; management of risk; and review of performance.  Your loan portfolio should be managed using these same basics.  Your loan officers are pitching various investments based on your overall investment goals (credit policy, pricing structure, etc.).  Your approval authority is the final review of these investment options.  Ongoing monitoring is management of the ongoing risk involved with the loan itself.

What is your vision for your portfolio?  What type of diversification model do you have?  What type of return is required to appropriately cover risk?  Once you have determined your overall vision for the portfolio, you can begin to refine your lending strategy.  I’ll comment on that in my next blog entry.

The pendulum has definitely swung back in favor of the credit discipline within financial institutions. The free wheeling credit standards of the past have proven once again to be problematic. So, things like cost of credit, credit risk modeling, and scoring models are back in fashion.

The trouble that we have created is that, in an effort to promote greater emphasis on the sales role, we centralized the underwriting function. This centralization allowed the sales team to focus on business development and underwriting, on credit.

The unintended result, however, is that we removed the urgent need to develop credit professionals. Instead, we pushed for greater efficiencies and productivity in underwriting -- further stalling any consideration for the development of the credit professional.

Now we find ourselves with more problem credits than we have seen in the past 20 years and the pool of true credit professionals is nearly gone.

Once this current environment is corrected, let's be sure to keep balance in mind. Again, soundness, profitability and growth -- in that order of priority.

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.”

Whenever an industry encounters problems, the natural tendency is to play the blame game.  In the banking industry, credit risk managers are looking for who or what to blame for the tide of charge offs and delinquencies in their under-performing loan portfolios and in their commercial loan origination operations.  Credit scoring has definitely taken it on the chin as an easy target during 2008. 

Is credit scoring the problem? Absolutely not! 

As with anything, the more complacent we become…and the more we “turn off our brains” and stop thinking…the more risk we assume.  The more we solely rely upon the credit score alone, the more we subject ourselves to the risks inherent in “score and go” lending.

We are all well aware that credit scoring measures propensity to repay and not capacity to repay.  Over the past several years, the propensity to repay has been boosted by ever-increasing real estate values and by the refinance boom.  For example, some consumers have been able to survive on a 50 percent debt–to- income due to constant use of credit cards …by paying off those cards with a home mortgage refinance.  That set of behaviors would have shown a propensity to repay…but  was it ever acceptable to have 50 percent of your income go to debt payments?! 

Statistically it may have worked for a few years, but once real estate values stopped escalating, the problem with lack of capacity to repay reared its ugly head. 

When it comes to risk management, let’s get back to reality and sound principles.

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.