A Fresh Look At Credit

The need for loan growth is acute across the industry. With a flattening and extremely low yield curve, investments are particularly unattractive and do not offer sustainable margins for prudent asset/liability management. Growing the loan book which has been shrinking for the past three years is the call to action. And yet the scars of the financial crisis are still present in most banks' balance sheet. With these scars comes increased conservatism in underwriting and general skittishness. What is an RM to do?

The first step to loan growth, even in the face of non-existent demand, is the credit function and the Chief Credit Officer. RMs are tired of getting beaten up when they come to loan committee with hard-earned deals that they pry away from competitors (which is generally the only source of new loans these days). At the same time, CCOs don't want to face another cycle of credit issues a couple of years hence as a result of relaxed underwriting standards. Below are some thoughts on addressing the delicate balance between conservative credit posture and the need for loan growth.

1. Clarify what's OK and what isn't For example, CRE loans have been verboten for most banks since 2008. First, the 300% / 100% regulatory limitation on real estate-based loans caught many banks widely over the limit. They had to spend years shedding real estate assets during a plummeting market, which is no fun. Second, the value of real estate in many markets is still debatable, especially given the posture of many appraisers who were initially over-exuberant about the markets and are now way too conservative- Lending against such assets has become a difficult proposition. And third, regulators require cash flow lending even when real estate collateral is involved, so global cash flow rules regardless to the underlying collateral.

Most banks spent the past three years bringing their real estate exposure way below 300%, and construction portfolios way below 100% of capital. While the market is not exactly bursting with activity, the question is: is it time to re-enter the business if you have capacity under the regulatory limits? Are the words "How much lower can it go?" famous last words, meaning we have not seen the bottom yet?

Recognizing that not all real estate was created equal (today apartments are doing very well, but single family is still generally ailing) and neither were different markets, different banks will have different answers to the question of whether it is time to get back into real estate lending. But if it is for your bank, it is critical to clarify what you expect from the relationship.

Clearly, returning to past real estate lending practices isn't a good idea, especially considering the lack of relationship orientation of large CRE projects. CCOs need to determine what credits are acceptable, with what loan-to-deposit ratios, and how much space is prudent for the bank to book more real estate loans on its balance sheet, Lenders are hesitant to get back into the markets when they are not sure what credits will be approved. Clarify that for them in crystal-clear terms to avoid mutual embarrassment and upsetting future prospects.

If this clarification entails rewriting credit policy, engage both the lending and credit teams to specify how to underwrite each one of your current and future loan products. This will facilitate reinforcing the credit culture and building consistency throughout the organization.

1.Improve analysis In preparation for loan growth, refine your analytical tools to detect early warnings on portfolio and individual credit deterioration. Sharpen your migration analysis; make your concentration reports more granular; find cross-portfolio relationships (e.g. oil and gas and trucking); etc.

2. Improve monitoring Revisit your credit maintenance requirements to make them both realistic and productive. Do you really need all those insurance certificate renewals or is it economical to buy insurance for them? What level of financial statement requirements (complied; audited; self-prepared) do you expect for annual review? And so on It also helps to have the lenders certify that their portfolios are graded correctly to improve accountability.

3. .Who makes the pricing decisions? Should it be the credit function or the line? First, crisply define whose job it is. Second, make sure you do not impair the RMs ability to make the deal work. So long as the credit function and the lenders are aligned on asset quality and the loan grade, pricing will follow.

4. Should you increase your risk profile today? Many banks are considering new lending businesses given the sluggish loan demand in bread-and-butter lending. If you elect to enter new areas, either geographically or by business, set firm and conservative volume limits on these businesses. Fast growth might help short-term performance, but is almost certain to come back to haunt you.

5.Tighten loan review process Banks' loan review expectations vary widely, from 40% of dollars outstanding to 90%+. Everyone agrees reviewing the largest loans and the higher risk loans is the first priority, but we also know that's not enough.

a. Pay attention to your smaller loan portfolios. Those files tend to be sloppier and cause you to bleed from a thousand cuts.

b. Attach loan review to the governance function to ensure independence.

c. Use outside vendors to help you review internal review effectiveness. When using these vendors, ask for their criteria for asset and file evaluations before retaining them. Transparency is helpful here. Do not use the external review solely as a risk rating function. They can and should contribute more. Keep the in-house and outsourced loan review teams fresh and independent to get the most bang for your buck. They should review processes, risk rating accuracy, credit administration and controls. Determine each year what the appropriate scope is and the frequency of their visits.

d. Loan review should be risk based but still touch all groups.

e. As a rule, a good approach is to stratify the portfolio by region, by lender, by asset quality and specialty business, then pull a meaningful sample and re-underwrite. Loan review should provide both risk and administrative ratings. Exam frequency should correlate with exam ratings.

f. A thorough and collaborative loan review function improves file maintenance and helps the RMs and their assistants stay focused on the overall portfolio asset quality.

g. It is good practice to review every new or renewed loan over a certain amount within 60 days.

h. It is also good practice for the credit function to approve all loan upgrades.

i. Loan review dos not absolve the RM from "owning" the risk rating and credit maintenance.

7. Appraisals Practices vary widely and regulators' expectations have been a moving target, but certain practices are universally sound.

a. Keep appraisal review totally independent from both the line and credit approval.

b. Appraisal processes must be consistent.

c. Set loan size benchmark to determine whether the appraisal will be done in-house (if you have that capability) or outsourced.

d. Renewals, term changes etc. for loans with old (over 12 months) appraisals require new appraisals.

e. Consider including in your loan documents the right to order an appraisal at any time to accommodate unanticipated future needs.

f. Make sure every piece of the process is 100% independent.

8. Pre-deal review Consider establishing a process where RMs can run by credit a deal very early on to see if it passes the "laugh test". This is not an approval or even a pre-approval, but merely an initial screen to help lenders spend their time productively and avoid embarrassment by chasing deals you will not approve.

Effective credit management in this new environment is quite challenging. Finding the right balance between conservatism and growth, finding ways to say "yes". and including it in the CCOs' definition of success, is not easy, but it is doable.