When an orchestra plays a symphony, a stellar performance requires, at a minimum, that each musician plays from the same page in the music. Ideally, the conductor also has ensured a standard technical competency among the musicians and has provided a framework for the musicians' interpretation of the notes.
Similarly, for a financial institution to have the kind of credit quality that it expects and that regulators increasingly want to see documented, it's critical that loan officers, credit analysts and other staff members start "on the same page" in their risk management processes. That's particularly true when it comes to how they collect data from potential borrowers, calculate ratios and interpret results.
Accomplishing this is at least as much an art as it is a science. Analysts and financial institutions will have different underwriting guidelines and standards. There also can be inconsistent procedures and methodologies within a financial institution, which can create some of the biggest challenges for credit risk management.
Recent regulatory enforcement orders requiring improved loan portfolio management have called for procedures that ensure conformance with loan-approval requirements and satisfactory collateral documentation. Examiners of the credit risk process want to make sure you're comparing apples to apples, and they want to see your work. Is everyone asking the borrower for the same set of information? Do borrowers know exactly which forms and schedules are included in the needed tax return you? The problem is that any of these factors can take a not-quite-good-enough credit and turn it into a "just barely good enough credit."
Other areas where inconsistency can creep in include:
1. "Spreading." Three analysts at the same institution may spread three tax returns into financial statements three different ways. For example, if a business sells an asset and makes a gain, do you count that gain as income or exclude it because it's not recurring? Doing it one way may make sense to one credit analyst, while doing it another way makes sense to the other two analysts. But now you're comparing those loan packages to make decisions, and you've got an information problem. It's back to apples and oranges.
2. Applying regulatory guidance. Are standards being applied consistently across the portfolio? For example, are the same metrics being evaluated for each borrower's risk rating score? Financial institutions need a systematic and consistently applied process for determining the allowance for loan and lease losses (ALLL). An incorrect allowance can misrepresent an institution's financial condition or its earnings, so having a consistent way to measure the extent of every loan's impairment is critical.
3. Data tracking and documentation. Is there adequate documentation for regulators and auditors of how risk ratings are derived? It's like math class; you might have the 'right answer,' but if you can't show how you got there, what's the point? It basically says you're guessing.
Financial institutions also must recognize that a lender's motivations may be different than a credit analyst's, and may require new procedures to ensure a consistent analysis. The key to combating inconsistency in the risk management process is credit culture. Establishing procedures for gathering data and a common understanding of certain relevant terms and definitions constitute a credit culture with fewer variations. A smart question is, "What is the cost to your institution of one bad loan?"
Technology is another key to creating a consistent methodology for entering data and documenting loans.
Depending on the solution you have, your technology can generate reports for loan grading, global cash flow analysis, and calculating reserves. If you have the ability to review inputs, you also can provide easier quality control.
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