Are Your Bankers Making Loans or Managing Credit Risk?

A tell-tale sign that winter is coming is the shrinking number of hours of daylight each day. As dusk falls earlier each day and as the sun rises later, we are reminded that summer has drawn to a close and cold weather is near.

For some people, this knowledge prompts the purchase of wood for the fireplace or salt for anticipated snowstorms. Others begin winterizing the house and having the furnace inspected. These people understand what’s likely to happen in the future, and they prepare for it.

It’s important for financial institutions, too, to recognize that tougher times could be ahead and to prepare for them as they develop the allowance for loan and lease losses, or ALLL. Anticipating potential problems starts long before the calculation of the ALLL, however.

Jeff Judy, a consultant to the financial services industry and founder of Jeff Judy & Associates, suggests that the daily activities can have a tremendous impact on the bank or credit union’s ability to “weather” future difficult times. At the 2015 Abrigo Risk Management Summit, Judy said credit risk managers should understand and emphasize to their lending staff three key credit concepts in order to best protect against future losses.

First, loans made today will be repaid with cash generated tomorrow, so lenders need to focus on how well their risk ratings measure potential volatility related to repayment, according to Judy. A financial institution’s risk ratings should be able to gauge the likelihood that the asset being financed will have to be liquidated, the likelihood that liquidation will generate adequate cash flow to repay the loan, and the likelihood that the cash flow will be available in a timely manner, Judy said. Risk ratings should have sufficient granularity to “adequately capture the nature of risks inside your institution,” he added.

Second, credit risk managers should emphasize to their bankers that preventing loans from costing the financial institution money is of central importance. “You do not get paid to make loan decisions; you get paid to manage credit risk,” Judy said of lenders.  “In today’s world, with the focus on growth, I think too many bankers lose sight of that.”

Lenders must anticipate future risks and prepare for them, and shifting the mindset of staff so that they focus on credit risk management is important, especially when it comes to applying risk ratings. Judy said that one way to determine whether risk ratings are being applied reliably is to calculate the average risk rating for each banker. Big differences in averages of staff may prompt more training or a portfolio realignment so that the least experienced bankers aren’t handling the loans with the greatest risk.

Third, financial institutions should ensure lending staff understands that each decision on a loan influences the quality of the entire loan portfolio and the financial performance of the institution. “Say yes to the credit you should’ve said no to? We call those charge-offs. If I say no to the credit I should’ve said yes to, I’ve left revenue on the table,” Judy said. “Let’s make sure our people understand that they’re not making loan decisions; they’re making portfolio decisions.”

By emphasizing these three basic concepts of credit, credit risk managers can contribute to a stronger safety net, including the ALLL, so that their institutions are well prepared when “winter” arrives again for the financial services industry.

“The goal [of the institution] should be, ‘We don’t care what’s going on in the economy; we still generate a profit,’” Judy said. “The role of credit risk management is to increase the likelihood we’ll have long-term consistent profitability.”