Study: Small Banks Faulty On Managing Credit Risk

To stave off massive losses during the next economic downturn, community banks must improve their credit-risk management systems, Robert Morris Associates recommended on the basis of a new study.

About 30% of the 126 community bankers surveyed use advanced credit-risk management techniques, according to the trade group for credit officers.

That means the vast majority of community banks could suffer a 1980s- style meltdown when the next recession strikes, warned Allen W. Sanborn, president of the group. "Bankers are never tested in good economic times," he said. "They are tested in bad times. Many community banks didn't make it through the last recession."

RMA said the survey sample, though small, is representative of the community banking industry, which it defined as banks with less than $1.5 billion of assets.

The group urged community banks to:

Improve how they rate loans' credit quality.

Revamp how loans are approved.

Price loans to reflect the risk of loss.

Better manage their loan portfolios.

It did not recommend specific changes for banks to make because it said the level of sophistication needed varies by institution. Rather, it urged overall improvement in how community banks handle credit risk.

"The purpose of our study was to take the best practices and put them in summary form," said Lee B. Murphey, chairman of RMA and executive vice president of First Liberty Bank, Macon, Ga. "It is a starting point."

Carolyn D. O'Leary, executive vice president of Annapolis (Md.) Banking and Trust Co., said the business has become so complex that community banks must adopt the latest risk management techniques.

"In this day and age of more information and more complexity," she said, "even community banks need these types of research tools."

The group devoted a significant chunk of the study to credit risk rating systems, which banks use to grade the quality of prospective loans. Community banks, on average, used 3.6 grade categories, compared with an average of 4.6 for the survey's high-performing banks, which were defined as those with sophisticated risk management systems that also earned above average profits.

Even the 3.6 average is partially misleading, the group said. It found that banks awarded more than half of their loans the same grade and that more than 80% of loans were split between two grades.

"There is a benefit to having more grades," said Mark A. Zmiewski, RMA's director of information products. "The idea here is to better define your risks."

For banks unwilling to add grade categories, RMA suggested subcategories be created in each grade by using pluses and minuses. This would force banks to specify the quality of their credits more finely, without having to completely revamp their systems, Mr. Zmiewski said.

The group also complained that community banks often base credit quality grades solely on borrowers' creditworthiness, ignoring whether a loan is secured or unsecured. That omission is crucial because unsecured loans are inherently more risky.

Community banks also do a poor job of pricing loans, RMA found. Only 22% of the banks surveyed use risk-based models to determine price-half the rate for the high-performing community banks. And at those that do use models, the actual price charged for a credit matches the model's rate only half the time, the survey found.

Unlike the average community bank, high-performing institutions rarely deviate from loan-approval policies, and they track the type and frequency of these exceptions.

Community banks also must better diversify their portfolios, the group said. Too many community banks concentrate on a single type of loan or focus on a single industry, it said.

For a copy of "Beating the Odds: A Community Banker's Guide to Risk Management," call 800-677-7621.

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