Feature | By Bo Singh, President, T. Gschwender & Assoc. Inc.
2017 is upon us. Improving economy. Rising interest rate environment. Stable net loan losses back to 2006 levels. New administration focused on reducing regulatory burden. Based on our experience of conducting loan reviews for over 30 years, here is what you can do to ensure credit concerns do not inordinately impact your financial institution going forward.
Setting Risk Tolerances
Good credit risk management starts with setting, and communicating, reasonable credit risk tolerance levels. This is the board of directors’ responsibility and cannot be delegated.
Banks that had the most problems during the last recession failed to adequately establish risk tolerances related to “industry” risk. Basically, the board of directors often failed to establish reasonable limits on industry concentrations to guide senior management. For example, banks that did well had limited construction/land development loans to less than 5 percent of capital. Whereas the banks that failed had much higher limits or did not properly monitor their concentrations at all.
Banks should clearly outline their credit risk tolerance limits in the loan policy and then continually monitor compliance with these limits.
Risk Rating Loans
Risk rating loans is not a simple process but it’s essential in managing credit risk.
A risk rating is dependent upon many variables and how these variables interplay with each other. It is not merely dependent upon on the Debt Service Coverage Ratio (DSCR). The days of simply stating risk rating definitions in your policy and then assigning those risk ratings to the bank’s loans are long gone. This dated approach has led to incorrect assignment of risk ratings, leading to miscalculation of the risk within the loan portfolio and unfortunately in some cases, failure of the financial institution.
Banks need to develop a sound structured methodology to assign the correct risk rating for each loan in a transparent and consistent manner. This methodology should be fully described in the loan policy and tested to ensure it is producing the proper right risk rating. There will always be some subjectivity involved in assigning risk ratings to commercial loans; however, having a good methodology in place can eliminate the majority of the errors resulting from this subjectivity.
Game Plan For 2017
Here are some important items to keep in mind as you manage credit risk this year.
Identify any variable rate loans that are to reprice in 2017 and 2018 and stress test their DSCR based on increasing the rates by 1 percent and 2 percent. Discuss results with borrowers where cash flow is tight.
It has been TGA’s experience that most banks will realize the greatest losses from commercial real estate (CRE) loans where the collateral value has significantly declined. These are primarily associated with investor owned properties where value is based on income approach using market rents at stabilization. Banks should monitor current Net Operating Income (NOI) for investment owned properties with the NOI used in the appraisals. NOI significantly less than those used by the appraiser can result in dramatic devaluation of the collateral property in case the loan becomes impaired, requiring large ALLL allocation. Management should monitor and report such loans in the Allowance for Loan and Lease Losses (ALLL) Report. Reserve should be increased periodically if NOI of a particular loan is not achieving stabilization and the loan is showing credit quality concerns.
Review your Pass/Watch loans to determine how you can mitigate any weaknesses in these credits. If most of your pass loans are skewed toward your highest pass rating, the probability is greater that you will experience credit challenges in an increasing rate environment or if the economy takes a downturn. We have learned that the majority of the loans that are rated Pass/Watch fall into three main categories.
Loans for which you do not have current financials and that are paying as agreed. Now, you don’t have to immediately move Pass credits to Pass/Watch once the extension periods for tax returns have passed. However, if the financials are two or more years old and the borrower is not responsive in providing them, then the loan should be moved to Pass/Watch. You simply do not know the current financial condition of the borrower to rate it otherwise. If you don’t have current financials and the loan is delinquent, you should risk rate it Special Mention or worse.
Loans approved based on projections. These are typically startup companies and it is uncertain if they will be able to meet projections. In these cases, obtaining quarterly financial statements to ensure projections are being met is essential. Typically, a bank will not upgrade or downgrade these loans until a full fiscal year performance is available for review and the stabilization period has passed.
Loans dependent upon the cash flow of the guarantors. In these cases, the borrowing entity (or your collateral property if a loan is made to purchase an investment property) does not show sufficient cash flow to service the debt. However, the owner/guarantor has sufficient liquidity or excess income to support the loan. The loan is essentially dependent upon your secondary source of repayment. Our experience has been that these are the loans that owners/guarantors will divest of first during a rising rate environment or during an economic downturn.
Make sure you have set good credit risk tolerance limits. Best way to do this is to use the Weighted Average Risk Rating (WARR). Once you are confident that all your loans are risk rated accurately, you can use the WARR to control how much risk is in your portfolio, monitor which segments of your portfolio have the greatest risk, and determine how much more risk you can safely take on. For example:
It shall be a goal of the Bank to maintain an overall WARR of all commercial loans at 4.251 or better.
No loans with exceptions will be considered if the WARR of the commercial loan portfolio exceeds 4.25, unless they are rated 4 or better.
WARR of all loans in a specific industry (NAICS Code) shall not exceed 4.25 if the industry is more than 25 percent of Bank’s Tier 1 Capital + ALLL (regulatory concentration limit). New loans in the industry will not be considered if the WARR exceeds 4.25, unless they are rated 4 or better.
Lastly, ensure investment in credit administration keeps up with your growing portfolio so it can be properly maintained.
Effectively managing credit risk starts by setting good risk tolerance levels. You must, at all times, know how much risk you are carrying in your loan portfolio. One of the best ways to do this is by using the Weighted Average Risk Rating. However, in order to use this approach, your loans must be risk rated properly. Hopefully, the guidance we have outlined in this article will help you toward achieving this goal.
If you would like to discuss the above topics in more detail, or if you need assistance in accomplishing any of these items due to your current workload, please contact us, we are happy to help. ■
T. Gschwender & Assoc. Inc. is a consulting company that has been providing services to financial institutions since 1984. Contact T. Gschwender & Assoc. Inc. at firstname.lastname@example.org.
Based on a 5 pass risk rating scale. Tolerance levels will vary based on how many pass risk ratings you have.