The Elements of a Bank's Credit Culture

During this unpleasant credit episode, there has been much discussion among analysts about banks' credit culture - that is, the way each bank exercises the disciplines of risk management.

It seems plain that little new equity will be available to banks whose credit culture is weak. But sometimes the judgment is hard to make.

The main way we tell a good credit culture from a bad one is by looking at the level of non-performing assets. However, this can reflect factors other than skill - for example, the simple good fortune of operating in a benevolent local economy.

The time-honored four Cs of credit are collateral, cash flow, character, and collection. But I have observed, bringing a little portfolio theory and business experience to bear, that managing credit relies on a somewhat different quartet: diversification, collateral, underwriting, and collection.

Diversification. Established portfolio theory holds that effective diversification reduces credit risk. It is impersonal but effective.

Diversification, when exercised along with basic credit scoring (a simple underwriting technique), seems the key to the credit culture of major consumer lenders. It has allowed the development of specialty credit firms such as credit card and auto-finance operations.

To put it simply, the law of large numbers works.

Collateral. Everyone knows that collateral is important, but only a few true asset-based lenders make it the linchpin of their credit culture. Those few, active remarketers of collateral, know their markets and values well.

Most lenders are reluctant to take title, being content to use the threat to encourage payment. But true collateral lenders don't bargain with borrowers (except on concluding that remarketing value had been misjudged). Collateral lenders take the collateral and liquidate it as quickly as possible.

Underwriting. This involves more than the credit scoring of mass-market credits like credit cards and mortgages, and more than the initial analysis of commercial loans. Underwriting includes continued monitoring of cash flows and an understanding the fundamental economics of a borrower. It is the relationship of a strategic vendor to a significant customer.

Underwriting, like venture finance, is time-consuming and requires independent judgment. Because it demands intense attention for as long as a relationship remains open, it is only for credits large enough to bear the freight, but not so large as to be clearly monitored by the capital markets and rating agencies.

Collection. "Anyone can make a loan," the old saying goes, "but only a few can collect them."

Bankers aren't the only people to whom collection discipline is important. It is also the front line for credit managers of small businesses. They know that timely reminders keep receivables down - just as community bankers know that their local borrowers don't want to discuss their past-due notes at every country club visit or Sunday service.

Collection discipline involves an appreciation of the levers that are effective on borrowers - their character and their pride and their need to use the collateral. Borrowers don't want the family to know that payments are falling behind on an important household account, the mortgage, or the car.

A Blend of Disciplines

Diversification, collateral, underwriting, and collection - a credit culture needs to integrate these disciplines.

Particular lenders or specialties may emphasize one more than another. The truly great credit operations use each in the proper place.

Since all banks that want capital know that a credit culture must be sold to investors, capitalists must remain wary. After all, what does it signify when local success in keeping credit losses low cannot be applied to out-of-market sorties?

But even if the lender's formal skills are too weak to prevail beyond the home turf, they may do just fine there. Local information ("How's business?") and relationships ("See you at the club on Saturday!") can supplement otherwise sketchy skills, offsetting a local concentration of assets and the sociable reluctance to seize collateral.

Mr. Powell is a principal in the investment banking division of Alex. Brown & Sons Inc., Baltimore.

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