As financial institutions’ commercial credit portfolios have expanded in recent quarters, regulators have increasingly warned against growing so quickly that risk management standards and processes fall behind.
Indeed, credit risk is expected to remain a top examiner focus in the coming months, given the low-yield environment and pressure on financial institutions.
Given the attention to commercial lending and related risks, financial institutions should consider three best practices for commercial credit analysis, which is the foundation of managing commercial credit risk:
1. Develop a thorough understanding of the borrower or counterparty.
2. Establish and monitor credit concentrations at a micro and macro level.
3. Ensure adequate documentation is obtained for ongoing credit-risk monitoring.
These best practices relate to recurring problems in credit-risk management that supervisors have called out as the direct or indirect cause of most major banking problems. “Severe credit losses in a banking system usually reflect simultaneous problems in several areas, such as concentrations, failures of due diligence and inadequate monitoring,” according to The Basel Committee on Banking Supervision’s “Principles for the Management of Credit Risk.”
Develop a thorough understanding of the borrower or counterparty.
A key part of analyzing a credit application is having enough information to understand the borrower or counterparty thoroughly. Many banks, however, find this task complicated by time constraints and the financial interdependence of a business owner and the business: personal assets are often pledged against the debt of the business, and business and guarantor financial assets are typically intermingled. A thorough understanding of the borrower’s financial condition requires a careful review of income statement and balance sheet information for both the guarantor and the business. For this reason, it is important for credit and lending departments to have standards for when and how to conduct a global cash flow analysis.
Reviewing a borrower’s industry and the borrower’s financial performance relative to industry peers can also help develop a thorough understanding of the applicant. Industry benchmarking provides a more accurate picture of trends and related risks in a particular industry, and the peer comparisons add context to reviews of the borrower’s financial statements and forecasts.
Establish and monitor credit concentrations at a micro and macro level.
Banks of all sizes are being asked by regulators to evaluate their loan portfolios under various potential scenarios in order to anticipate and plan for adverse situations that might otherwise put the institution at risk. But even earlier in the lending process, banks and credit unions can manage credit risk by establishing and monitoring credit concentrations. Credit limits at both the individual borrower level and the industry level can help to contain exposure. A common source of major credit problems, according to the Basel Committee’s guide on credit risk, is when “banks identify ‘hot’ and rapidly growing industries and use overly optimistic assumptions about an industry’s future prospects, especially asset appreciation and the potential to earn above-average fees and/or spreads.”
Establishing and monitoring credit concentrations can help the bank or credit union take risk-mitigating steps, such as closely monitoring industry data, pricing for the added risk or using loan participations to reduce exposure to a particular sector.
Ensure adequate documentation is obtained for ongoing credit-risk monitoring.
A recurring problem among troubled banks has been the failure of banks and credit unions to monitor borrowers or collateral values, and often, this issue stems from failing to obtain periodic financial statement information or real estate appraisals during the credit analysis process. A financial institution can hardly evaluate the quality of its loan portfolio or the adequacy of its collateral or allowance for loan losses and reserves without accurate, timely information on areas appraisals and financial statements. Strong credit policies will outline the information and documents needed for loan approvals, for changing terms of previously approved loans and for renewing credit. But it’s important to put those policies into practice and to develop ways to track exceptions and to monitor updated documentation requirements.
Chuck Nwokocha leads the Advisory and Bank Consulting team at Sageworks, focusing in Credit Analysis, Risk Rating, Stress Testing, and Allowance for Loan and Lease Losses (ALLL). Chuck is a graduate of Harvard University, with a B.A. in Psychology with a focus in Organizations and Economics.