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Credit Risk Extensions

By Charles M. Steele


For many community bankers, talking about enterprise risk management is a good way to make their eyes glaze over. This is a natural reaction when first confronted with any new program that appears to increase expenses without any offsetting economic benefit that will increase the bottom line.
It may be easier to think of enterprise risk management in terms of a natural extension of credit risk management. For many years now, community banks have been adopting some of the credit risk rating practices of larger banks. In a sense, credit risk ratings for community banks became a fact of life with the recession of the late ’80s and early ’90s. All of a sudden, community bankers were being asked to be more proactive in identifying the risks inherent in the bank’s loan portfolio, before the loan suddenly appeared on the delinquency or non-accrual reports.
Today, credit risk ratings are a standard component of any bank’s loan policy. While regulatory guidance doesn’t dictate the risk rating system criteria, it does expect the risk rating system to eventually tie into the regulatory classification of assets (i.e. special mention, substandard, doubtful and loss). The complexity of the bank’s loan program should drive the complexity of the credit risk rating system. Many banks have simply identified three or four pass grades and tend to cluster the bulk of their rated loans into one average category. Unfortunately that doesn’t say much about the true risk inherent in the banks’ loan portfolios.
Community banks remain one of the bastions of new residential construction lending, working with many small contractors and developers on individual construction loans or subdivision loans. Given the current slowdown in the real estate market, a viable credit risk rating system should quickly identify those contractors and developers who have the staying power to wait out the market and those who may be overextended and are having to fire-sale properties to meet their debt service obligations.
Similarly, the meltdown in the subprime market could have an adverse effect on multifamily investment properties. A good credit risk rating system should quickly identify those borrowers who have adequate equity and reserves to sustain their debt service through a reduction in rental income.
One way to improve the risk rating system is to develop a matrix of criteria that defines the components that make up the credit risk rating. For example, to be rated  a “2,” the loan might need to have a debt service coverage ratio greater than 1.5 times and a loan-to-value ratio of less than 70 percent. A simplistic matrix of risk rating criteria might look like the table below.
Additional columns could be added for other criteria that should be considered, such as credit score, deposit relationship, quality of management or quality of collateral. Additional rows could be added to include criteria for the more serious classifications of Doubtful and Loss. Some banks may want to insert an “Acceptable” risk rating just below the “Average” rating to rate loans that fall within policy guidelines but have some inherent potential weakness, such as a new start-up business or an industry segment that is perceived to carry a higher risk during an economic downturn, such as residential construction.
Using a matrix forces a more subjective analysis to arrive at a credit risk rating score. With a truly effective risk rating score, validated by an independent loan review process, the bank is in a better position to first evaluate the quality of its total portfolio and second to segment the quality of each loan officer’s portfolio.
Carrying the analysis further, the bank can look at risk ratings across industry concentrations, loan types, property types and loan terms to begin to see potential changes to the portfolio quality in different economic scenarios.
Another important benefit of an effective credit risk rating system is in loan pricing. Somewhere along the line, we were taught that interest rates should reflect not only the time value of money, but also credit risk. Clearly, a corporate bond rated AAA will carry a lower interest rate than an A-rated corporate bond with a similar maturity. The natural extension is to use the bank’s credit risk rating policy to lead to better pricing decisions. Adding an extra 12.5, 50 or 100 basis points to the interest rate on a somewhat riskier loan makes good business sense and gives loan officers another tool to attract and maintain quality relationships. Too often, we see a time-consuming, weak relationship carrying an interest rate identical to a much stronger, less time-consuming relationship. While there is a lot of competition today for good commercial loans, there is also a need to price loans appropriately to reflect the degree of risk involved in the relationship.
There is a way to create an economic benefit from the sometimes routine business of assigning credit risk ratings, by enhancing the process to improve pricing decisions. Take that concept a step further as part of enterprise risk management and utilize the exercise as a means to better identify, improve and properly price the bank’s products and services.

Charles M. Steele is the principal of Steele Assoc., a Worcester, Mass.-based management consulting company working with financial institutions throughout New England.

Posted on Wednesday, April 04, 2007 (Archive on Tuesday, July 03, 2007)
Posted by Scott  Contributed by Scott


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