All banks recognize that a downturn in the credit cycle is inevitable, but only a handful are aggressively doing something about it.

These leading North American banks are investing in advanced credit risk measurement tools and portfolio management techniques that set them apart in their ability to both serve their clients and make sound business decisions. Armed with metrics, information transparency, and sophisticated models, these banks are forging a new approach to commercial lending that may well separate the winners from the losers over the next credit cycle.

This small group of 20 to 25 institutions are each spending $2 to $15 million annually to pioneer innovative approaches to credit management. Fully 30% of North American banks, however, are still at the starting line, adhering to conservative discipline and tried-and-true exposure limits. The gap between the innovators and these traditional "buy-and-hold" banks is wide and growing-and will have profound implications over time.

This is one of the conclusions of a comprehensive assessment of credit portfolio management practices at 64 of the 70 largest banks in North America, conducted by First Manhattan Consulting Group, under the auspices of Robert Morris Associates.

As they have in the past, many of the "just say no" banks will successfully navigate an adverse market through disciplined origination/underwriting, active profitability management, diligent concentration management, and strong workout procedures. Although past success may provide little incentive for change, we conclude that banks following a conservatively executed, buy-and-hold strategy will be less competitive as they vie for an ever-narrowing slice of a lower-margin market.

Moreover, new competition from investment banks and end investors, increased commercial loan securitization, and the development of credit derivatives have intensified a 30-year trend of disintermediation in commercial and industrial lending. Taking into account regulatory capital requirements, tax disadvantages, and higher perceived funding costs versus other investors, banks can efficiently hold fewer and fewer commercial loans.

As distinctions between the lending and securities businesses continue to blur, even the most successful traditionalists will need to adopt these advanced practices to compete effectively.

Seventy percent of the institutions in our study have taken steps to upgrade their credit risk management practices and, as a result, are better prepared for a credit downturn and growing pressure on lending spreads. The top 25% of these banks are characterized by a consistent set of best practices that create significant competitive advantage:

Business strategy-Leaders set flexible risk limits, develop solutions to poor market pricing, and provide more proactive day-to-day guidance to relationship officers about desirable credit exposures. Though apparently taking on more risk, they actually can better diversify their portfolio over a wider spectrum of risks.

Conversely, the most traditional banks treat market prices as a given, and hold their loan originations without full consideration to risk concentrations.

Risk grading-Traditionalists assign only four or five credit grades to performing loans, but leaders assign six to 19 grades. Two sets of grades are often assigned: one for default likelihood and another for potential loss severity. This precision allows these banks to more accurately gauge, price, and cherry-pick the most desirable credits.

Risk pricing-Leaders systematically calculate risk-based prices, and compute line-of-business and customer risk-adjusted returns on capital. Traditionalists who attempt this approach often have less conviction to act because their measures are less accurate.

Portfolio grooming-The most sophisticated practitioners use correlation-adjusted, portfolio-based measurements to select credits to be sold or hedged. They are experienced users of loan syndications, secondary markets, and credit derivatives to diversify their portfolios or create a better return on their correlation-adjusted risk.

Organization and governance-Replicating the interplay of bond issuers, investors, and rating agencies, a number of leading banks are structuring their lending activities to create healthy organizational tension between relationship managers who advocate loans, portfolio managers who purchase, decline, or sell loans, and credit groups that assess loan and portfolio quality.

The most advanced practitioners identified a number of obstacles that must be overcome before these best practices can be fully utilized. They include distrust of new risk measurements, concern about disrupting client relationships, reluctance to sell below par, the drive for more loan income, and organizational difficulties in redefining appropriate roles for relationship and portfolio managers.

For banks still at the starting gate, these best practices provide a road map for evaluating strategy and prioritizing initiatives. The availability of new grading techniques and vended risk measurement models, as well as bond and loan data from both Moody's and S&P, have lowered the cost of entry. Until recently, many of these techniques required extensive proprietary development.

The stakes have never been higher for shareholders, including paper-rich bank executives, because stock prices of U.S. banks have doubled and tripled since the early 1990s. Our analysis shows that the stock market reacts quickly and differentially to loan losses.

In the period 1989 to 1997, banks with lower loan losses realized a 56% higher annual total return and only half the price volatility of banks experiencing poor credit performance. In the last credit downturn, 1990 to 1992 or 1993, low-loan-loss banks rebounded to their 1989 share price highs in about 18 months, but high-loan-loss banks took more than 36 months to recover. For many, this presented a significant impediment to making acquisitions during one of the industry's most active consolidation periods.

We believe this differentiated stock valuation pattern will return-and may be heightened-during the next downturn. This differentiation will cause more intense scrutiny of the losers, as well as greater rewards for banks with above average risk/return performance.

One fact is clear: The pace of change in commercial banking is fast and accelerating. Banks that are acquiring the tools and skills to capitalize on advances in data quality, risk grading, pricing/performance measurements, and portfolio-based risk measurement are creating widening competitive advantage.

On a day-to-day basis, these advanced tools enable better decision- making and facilitate new ways to meet clients' needs. When the next downturn comes-as it inevitably will-leading banks will probably see lower losses and, importantly, superior stock performance. Given the upside potential and the downside risk, investment in credit risk measurement and portfolio management may be one of the best opportunities in banking today.

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