By Jeffrey Marcotte
The Dodd-Frank reform law has been signed, and the specific details are expected to be worked out by regulators over the next 12 to 24 months. However, the pressing issues raised in the legislation – risk management, accountability, transparency and uniformity – give us some insight into what examiners are going to be focusing on moving ahead.
While the law will have the greatest direct impact on commercial lending institutions with assets of $10 billion and above, there will be a trickledown effect that will impact smaller institutions. Examiners will be using Dodd-Frank as a guideline for best practices which will apply to banks of any size. Credit risk management will definitely be placed under the looking glass. In the meantime, lenders have an excellent opportunity to get ahead of the game.
First Trickle-down from
An early example of the trickle-down effect, on Nov. 9, 2010, the FDIC issued a proposed rule for the Federal Deposit Insurance Fund (DIF). In an effort to rebuild the fund to adequately cover future losses, it will begin charging heftier insurance premiums for banks in higher risk categories. These premiums are impacted by two key factors: a bank’s CAMELS rating and its capitalization. If a bank’s CAMELS rating improves and its capitalization is high, it will be placed in a low risk category and will pay lower insurance premiums.
This is significant for commercial lenders because asset quality (and whether we like it or not, good loans) plays a large part in the CAMELS rating equation. Effective credit risk management practices help banks strengthen asset quality by putting good loans on the books that generate positive returns. This in turn, improves institutions’ CAMELS ratings – and they can realize big savings in deposit insurance premiums.
This is just one area where we’re already seeing the effects of the law and there will be many more to come, but the bottom line is that banks have to start lending again to make money. That’s why there is so much emphasis on looking at the asset side of the balance sheet. To make good loans that generate the earnings their shareholders are expecting, institutions must have in place sound lending practices and take a proactive approach to credit risk management.
Establish Uniform Processes
Commercial lenders have some time before they will be forced to specifically address the issues that fall out of the reform legislation. If they establish best practices today for complex credit analysis and portfolio risk management, they will be able to address those issues and examiners’ expectations head on. Technology is essential to that effort. Innovation is coming to the rescue to help lenders effectively assess and mitigate complex credit risk (i.e. commercial real-estate, commercial and industrial, small business, construction and agriculture loans) in ways not possible before.
Here are three key areas where institutions should be focusing in the coming months.
Standardization. It will be crucial moving forward that banks standardize their lending processes across all commercial loan disciplines. Technology has evolved that aggregates data into one system of record for the lending area, similar to what the core processors provide. Lenders can now obtain, for the first time, a clear view into the risk that lies across all loan disciplines, and down to the individual loan level. Examiners will be specifically looking to see that banks are breaking down data silos and taking advantage of technology to put a repeatable process in place for identifying risk and uniformly managing all of their loans, from origination through payoff.
Visibility. Examiners will expect banks to have greater visibility into each loan so that they can take a more proactive approach to each borrower relationship. The only way to really evaluate risk is to get a complete picture of customers at macro and micro levels; some may no longer fit the bank’s risk profile and actions need to be taken to make them a better fit. Lenders also need to be able to see the overall risk make up of their portfolios in order to identify where they should focus on attracting new borrower relationships. Utilizing advanced reporting and analysis tools, banks can gain the visibility – all the way up to the board of directors – that’s crucial to making sound, profitable loan decisions that will improve the bank’s overall performance. And, it instills confidence in the examiners that the bank truly has a handle on its credit risk.
Stress Testing. To really be proactive, banks will need to be stress testing loans at individual and portfolio levels. One of the most compelling advances in lending technology is the predictive power offered by new risk management tools that provide modeling and pre- and post-approval stress testing capabilities that allow you to avoid potential credit problems well before they become problem loans. If commercial lenders can readily identify problematic loans early on, they have a much better chance of maintaining a healthy asset. Examiners are going to place heightened emphasis on stress testing loans and putting risk rating systems in place that will allow for thorough portfolio analysis. The latest technology innovations enable lenders to look at loan risk overviews by interest rate and risk rating, evaluate risk concentrations and run sensitivity analyses – to actively manage borrowers’ risk.
Take Action Now
With the passing of the reform law, we can see where regulators are going to be focusing their attention moving forward, and even though all the details are still being ironed out, commercial lenders have enough ammunition to be able to launch a beneficial preemptive strike. By embracing automation and applying best practices now to some key areas, institutions will not only be able to meet future regulatory requirements for credit risk management with confidence, but also drive more profitable loan businesses.
Jeffrey Marcotte is vice president of lending strategies at WebEquity Solutions.