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12.31.2020 Jacqueline Maduneme

How to Improve Credit Risk Management in 4 Simple Steps

Are you concerned about managing your organization's credit risk? Is your company following loss mitigation best practices? If you're interested in improving credit risk management in your organization, we can help. You can follow the steps we discuss in this article to establish procedures and protocols to improve your organization's credit risk management.

4 Steps to Improve Credit Risk Management

Credit risk management (CRM) aims to maximize a bank's risk-adjusted return rate by maintaining credit risk exposure within acceptable levels. In doing so, banks should consider the relationships between credit risk and other risks as they build out their credit risk management program.

Credit risk management is a critical component of a comprehensive approach to risk management and essential to any banking organization's long-term success.

For most banks, loans are the greatest and most obvious source of credit risk. However, there is credit risk associated with other bank activities, including in the banking and trading books, both on and off the balance sheet. Banks are also increasingly facing credit risk (or counterparty credit risk) in various financial instruments other than loans, such as acceptances, interbank transactions, trade financing, foreign exchange transactions, financial futures, swaps, options, and settlement transactions.

Specific credit risk management practices may vary among banks, depending on the nature and complexity of their credit activities. But their credit risk management program should address credit risk in all of the bank's activities, including risks inherent in new products and services, and address it at both the individual credit and portfolio levels.

By assessing all their services, rather than focusing on the riskiest, banks can ensure all bases are covered. There are a few missteps organizations typically make when building a credit risk management program:

  1. Viewing credit risk in isolation,
  2. Not addressing credit risk inherent in all their products and activities, including products and services new to the bank, and
  3. Accounting for credit losses.

We have already touched on the first two. Regarding the third misstep, in 2016, FASB released Accounting Standards Update No. 2016-13 on measurement of credit losses on financial instruments. It resulted in significant changes to credit loss accounting under US GAAP. The revisions included introducing the current expected credit loss methodology (CECL), replacing the incurred loss methodology for financial assets measured at amortized cost.

In 2019, the banking regulatory agencies issued a final rule that revised specific regulations to account for these changes. The 2019 CECL rule revised the agencies' regulatory capital rule, stress testing rules, and regulatory disclosure requirements to reflect CECL. The rule includes a transition period that allows banks a 3-year transition period.

On March 31, 2020, as part of efforts to address the disruption of economic activity in the US caused by the pandemic, the agencies adopted a second CECL transition provision through an interim final rule, effective September 30, 2020.

Now, let's look at four steps you can take that will improve your credit risk management program.

1. Review and Monitor Covenants

Covenants are conditions agreed to by the borrower as part of the terms of a loan. Effectively monitoring covenants can provide lenders with an early warning of loan deterioration. Most problems handled early on do the least amount of damage. Loans starting to lose stability are no exception.

2. Know Your Customer

To activate high-value credit risk management activities, you must operate with accurate information related to your customers' activities. The customer information you keep on file and the relationships you form are crucial in establishing yourself as a valued financial consultant. Moreover, through relationship-building, you can operate with increased agility, proactively identifying issues that may prevent your organization from managing credit risk effectively.

To appropriately structure a loan, you need to understand your customer's business. Before completing a financial analysis of the organization, identify the characteristics that influence a company's success by studying:

  1. The nature of the business.
  2. The nature of the industry.
  3. The impact of economic conditions.
  4. The business strategy.
  5. The competencies or deficiencies of management.

You need to understand the industry and economic factors influencing your customer's business. You need to understand how they affect its financial conditions and stability. Learn about the company and how it operates within its industry. Evaluate the company's management and business strategy. Once you've completed your business analysis, then turn to the financials. With all your information in-hand, you can now appropriately structure a loan that is right for both your customer and your bank.

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3. Identify Loans Against Non-Financial Assets

Many bank's credit activities involve lending against non-financial assets. For example, asset-based business lending and commercial real estate lending. In these types of loans, many banks fail to make an adequate assessment of the correlation between the financial condition of the borrower and the price changes and liquidity for the collateral asset. Since there may be a relatively high correlation between the borrower's creditworthiness and asset values, a decline in the borrower's income stream due to industry economic problems may be followed by a decline in asset value for the collateral. This will in turn affect the borrower's ability to meet its obligations in accordance with agreed terms.

4. Keep Up With Regulatory Changes Impacting Credit Risk

As a trusted risk advisory and technology solutions service, Compliance Core’s technology stack enables organizations to proactive monitor, manage, and mitigate regulatory change and infractions. Our system automatically extracts and displays regulatory requirements from proposed and final rules, and provides a workflow to analyze impact and implement applicable changes.

In this way, organizations can stay up to date on regulatory changes, prioritize compliance updates across the organization, track implementation across departments, and execute effective risk and control self-assessments.

At Compliance Core, we understand the importance of hiring the best risk management consulting partners possible. That's why we take extra care in making sure all of your questions are answered upfront and make sure you know everything our firm can do for you right from the start. We manage all aspects of enterprise compliance and risk management for small banks. Our website offers a free self-assessment to show you how you perform against risk management and compliance best practices.

To find out more, check out our page, How Mature is Your Risk Management and Compliance Program?

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Published by Jacqueline Maduneme December 31, 2020