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How do you manage Credit Risk at your bank?

Date: March 1, 2014 Author: Ramzi Watfa
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In one of the meetings I had with a bank trying to sell our CRM program, I was told that they like to train their participants on credit risk “Our Way”. I suggested I met with both business and risk over a two days period to try and understand the way the bank functions, identify the bank’s “way” of doing things, and see what changes, if any were needed to the training program to ensure we capture it and satisfy the client’s needs.

Credit Risk Methodology Before getting into detail, let us just shed light on what is the aim of 6 Sigma’s Credit & Relationship Management (CRM) program. The training on credit risk is centered on 5 objectives:

  1. Identify the credit risk of customers (we call them obligors).
  2. Identify customer needs.
  3. Decide on the appropriate share of wallet of customer’s business given customer risk profile (to preserve the portfolio risk rating).
  4. Decide on an appropriate pricing to balance the risk.
  5. Finally identify cross sell opportunities to improve RORAC and the bank’s overall Revenue to Expense ratio.
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Differences in Approach The above credit risk objectives are applicable to all banks, irrespective of size, location, portfolio, and type of banking (Islamic or Conventional) as ultimately the aim of the business is to optimize the return to the bank’s shareholders over time. This aim is becoming more focused given the move towards an IRB approach that requires more discipline in measuring and managing credit risk. In the world of Standardized banking, customers are treated equally, and the emphasis is on growing assets with as high a spread as possible. In the world of IRB, it is the type of asset you grow that is just as important. The measurement of Expected Loss (EL) is therefore very important at a very early stage of credit risk analysis. EL is the combination of Probability of Default (PD) and Loss Given Default (LGD).

What is Default then? In any case, PD is PD whichever bank you are in. As per Basel Guidelines, the first definition of PD is the obligor being “unlikely to pay”, which is forward looking not simply based on past or assumed performance. The use of both leading and lagging indicators are therefore very important, hence the added reliance on qualitative measurements, less reliance on traditional ratios, and ability to sensitize the obligor. In the world of forward looking default, cash flow analysis (and its ratios) become centric to analysis, whilst peer analysis proves to be very misleading (the blind leading the blind syndrome). The earlier the bank can detect defects in a client (early problem recognition), and keep an eye on them, the better control the bank has on its portfolio. The methodology that we use in our training uses up to 177 different criteria to measure PDs, the most exhaustive of all training programs. These are aimed at identifying defects before the account is booked, and helps devise ways to ensure that monitoring remains focused and effective.

What are losses then? LGD is how much you are likely to lose once default happens. This includes both write offs and interest drag, the cost of funding the account from day of default until full settlement. So even if write offs were zero (the argument with real estate lending from most emerging market banks), the bank continues to incur expenses whilst funding the account during the period of default. Even if full interest is collected on full settlement date (at the end of the relationship), the present value of this interest represents the opportunity cost of using the funds elsewhere.

Studies conducted by Citibank, JPMC, Moody’s, S&P and others indicate that increased structuring reduces LGD by as much as 60%; so understanding facility structuring is a crucial element in managing LGD. In our training program we aim to manage the LGD through (a) appropriate structuring of the facilities in line with obligor needs, and (b) align the bank’s exposure and pricing with the risk profile of the obligor. With increased obligor credit risk (a) pricing is to increase to compensate for this risk, (b) structuring of the facilities is to be appropriate, and (c) the limits are to be very well controlled, what we term Share of Wallet.

So how is PRR managed then? Control the Portfolio Risk Rating (PRR) and you maximize the return to the shareholder. This is what an IRB RAROC measures. Measuring risk, quantifying it (through the PRR methodology that we teach) and controlling it is a crucial and well adopted Best Practice in best in class banks. The only thing you have to worry about as a bank is:

  1. Am I calculating PD, LGD, EL, UL, and PRR right?
  2. What early warning signs am I using to ensure forward looking PDs?
  3. How do I structure the facilities to manage LGDs?
  4. What collateral security is eligible to help in this control (haircuts etc) and
  5. Do I have Product Programs to manage the underlying risks?

Then what is “doing it our way” means? Surely this must mean balancing perceived risk on one side with returns on the other; or simply put a balanced risk appetite. However if measurement of PDs, LGDs, and PRR were inappropriate, then perhaps this risk appetite is unknowingly too high. You may not see the affects immediately (you never do), but when you have a problem account that eats a large chunk of your profits, or when you switch into IRB full gear, then you really have to ask yourself what sort of assets were being booked.

To avoid this scenario, one needs to use the PRR to measure portfolio risk and then decide how much of a risk appetite is really needed. So for dealing with higher rated obligors (higher PDs), to maintain ELs at an acceptable level (a level that will not impact the PRR too much), one needs to control LGD. To do this you have to structure: use PPF financing for contractors, enhanced TM and RACs for SMEs, increase data management for RMs to deal with SMEs without financials, link the financing to receivables (receivable discounting), calculate ability to settle and use a suitable DSCR for term financing, and so on.

So do you do all of these things at your bank? If not, best get started by being trained. Visit our https://www.credit-risk-store.com/to see what is on offer.

Back to the Visit During my visit to the bank, I was looking out for the methodology used in performing credit analysis, and trying to identify what we were missing in our CRM program so that we could make the necessary changes to ensure we captured the bank’s “way of doing things”. In the process we also looked at what was currently being practiced and compared it with what would be under a Basel-conducive environment, and one that is done using best practices. We also had the benefit of feedback from senior personnel in business and risk who had a particular view of how things are managed at the portfolio level.

Our findings vindicated what Basel discovered in its deliberations:

Inadequate Risk Assessment

  • Approving credits based on simple indicators.
  • Lack of testing and validation.
  • Subjective decision making by senior management.
  • Lack of risk-sensitive pricing.

Lack of Use of Analytical Techniques

  • Lack of accounting of business cycle effects.
  • Lack of consideration of a downside scenario.
  • Lack of forward-looking methodology.
  • Lack of use of cash flows.

Lax Credit Process

  • Lack of an effective credit review process.
  • Failure to monitor borrower or collateral values.

How does this tie in to the CRM program? In other words, all of the practices in the bank were a small subset of the 177 different criteria that we use in the program. There were other areas that were lacking:

  1. Too much reliance on lagging indicators (Current Ratio, Leverage etc)
  2. Lack of Target Market study and risk acceptance criteria to help manage the PDs
  3. Lack of Industry Studies to help in the marketing effort
  4. Lack of Product Programs for structuring facilities and managing the LGD
  5. Lack of Portfolio Risk Rating measurement and related strategies

Perhaps because we delve into these topics in the CRM program in the first place, there is a perception that the program did not cater to “our way” of doing things. If the bank wished to become IRB compliant, or at the very least be able to identify problems early, these issues need to be instituted in due course. Our CRM program prepares the officers for that eventuality and allows the implementation of these in an effective and practical manner.

So what do I need to do to better manage trainees? If the management of trainees from a CRM course was done in the right fashion, then (a) control over the portfolio would remain tight, and (b) the bank would have a means to ease it into an IRB environment, which is the ultimate aim in due course. These controls are not a hindrance to booking new deals. On the contrary, if managed well, they will help officers specify the right structures to book with the confidence that control over the portfolio will remain intact.

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