Effective credit risk management is critical for the viability of your institution. Help safeguard your lending program by learning about the following eight elements of managing credit risk.
Know Your Customer
Knowing your Customer is essential because it is the foundation for all succeeding steps in the credit process. To be successful, you must operate on pertinent, accurate, and timely information. The information you gather and the relationships you establish are critical to positioning yourself as a valued financial consultant and provider of financial products and services. Establishing a good relationship can bring a long stream of equity to your institution.
A poorly planned and executed initial call could limit your opportunity for future business. One of the best ways to get to know the customer’s needs and establish yourself as a valued financial consultant is through face-to-face meetings to discuss the customer’s history and future plans. Prior to meeting with the customer, you should find out as much as you can about the company and its industry. This up-front exploration will allow you to make the most of the time that you have with the customer and help you set up an effective calling plan to guide you through the interview process. You should make sure that you elicit all key information, keeping in mind that the most important skills you can demonstrate are the ability to listen effectively and to respond to a customer’s needs. Listen for verbal cues and watch for non-verbal cues to help establish a customer’s needs.
During the initial interview, establish your credibility as a professional, knowledgeable, and friendly businessperson. Ask questions and gather information about the company’s products and services, customers, suppliers, facilities, management, ownership, and history. This is when you can develop your initial observations about management’s behaviour and start to evaluate their qualifications and abilities to carry out the company’s business strategy.
On subsequent calls, investigate competition, market share, and the probable impact of economic conditions on the business. And identify the company’s business strategy and what the company must do to succeed.
Analyze Non-financial Risks
Understand your customer’s business by analyzing non-financial risks. Information gathered in this step is critical to positioning yourself as a financial consultant to your customer and a valued member of your financial institution’s lending team.
The concept of risk management can apply to a single loan or customer relationship (micro) or to an entire loan portfolio (macro).
The whole concept of institutional risk management is to ensure that a particular issue has been identified as a risk. At the micro level, a loan is a risk. At the macro level, a portfolio of loans is a risk. Your credit policy department will identify risk factors and query the entire loan portfolio (macro) to judge whether the particular risk is relevant to other customers of your institution. The key question is, “How does this identified risk affect a company’s ability to repay debt?”
Risk Management is a continuous process (not a static exercise) of identifying risks that are sometimes subject to quick and volatile changes. The identification of risks may result in opportunities for portfolio growth or may aid in avoiding unacceptable exposures for the institution.
There is risk to every line item on the balance sheet and income statement and you must learn how to evaluate those risks, which fall into the broad categories of:
- Industry
- Business
- Management
The integration of the analysis of risks associated with the industry, business, and management of a company is a critical piece in the overall credit underwriting process. From your institution’s perspective, senior credit policy management wants to know:
- Is there enough capital available on the institution’s balance sheet to support the risk being taken?
- Is the institution being adequately compensated for the risk?
- Are there adequate controls in place at the institution to assure the proper tracking of the risk and minimize the element of surprise?
Evaluating industry, business, and management risks enables you to ask questions of customers and prospects in order to fully identify, quantify, and if possible mitigate key risks. As a result, you develop critical thinking skills that integrate economic, political, and market issues into the overall underwriting process. Assuming the loan meets underwriting and credit approval criteria, properly analyzing these risks gives you the information to help structure the loan in a fashion that will ensure the highest probability of repayment.
Analysis of the industry, business, and management risks precedes or is concurrent with financial analysis of an individual company. If the financial institution has, or wants to gain, a significant exposure to a particular industry, it usually has industry experts on both the lending and credit analyst teams. Industry experts provide an intimate knowledge of an industry and will,
- Identify, understand, evaluate, and mitigate risk.
- Provide expertise in the event of a loan workout situation with a customer.
- Provide efficient marketing strategies in acquiring creditworthy and profitable clients within a particular industry.
An understanding of the economic and industry factors that influence a company’s financial stability and financing requirements is necessary before evaluating the numbers. Because you can’t analyze a company in a vacuum, it must be analyzed within the larger context of its industry and the world economy.
Industry, business, and management risks are inherently an important part of the overall credit underwriting process. A company’s financial statements are a rreflection of a company’s management decisions as that company interacts with the outside world. Industry, business, and management risks (nonfinancial risks) describe that outside world.
Understand the Numbers
There are many benefits and risks associated with establishing a banking relationship with any entity or individual. As a lender, you should know:
- How the requested funds are going to be used and how they are anticipated to be repaid.
- How to identify, categorize, and prioritize all of the risks inherent with the customer that are known at the time of the analysis as well as those that are anticipated to be in existence over the period of the relationship.
To understand the numbers you should focus on the financial capacity of the company as evidenced by the information provided and examine the accuracy of the information as well as the quality and sustainability of financial performance.
Before beginning any financial analysis, it is important to understand why companies and individuals borrow money.
Why Do Companies And Individuals Borrow Money?
When dealing with new clients, it is doubly important to probe into how and why the loan request originated. When loaning to established relationships, your assessment of the loan will be guided by your knowledge of the changes in your customer’s asset structure as it goes through its business cycle.
The reason for borrowing provides you with insights into the company’s ability to repay. A complete understanding of the historical and projected financial performance of your customer is key to your analysis.
The loan request is generally the most scrutinized part of a credit write-up. Once you are comfortable with the nature of the loan request, the process of understanding the numbers can begin. The process includes:
- Knowing the Auditor – Analyze the competency and reputation of the firm or individual preparing your customer’s financial reports.
- Accounting Fundamentals – Review the auditor’s Engagement Letter, Financial Statements, and Management Letter, as well as accounting fundamentals and generally accepted auditing principles (GAAP).
- Balance Sheet Quality Analysis –Analyze the balance sheet along with relevant liquidity and leverage ratios.
- Income Statement Quality Analysis – Analyze revenues and costs along with income statement ratio analysis
- Cash Flow Statement Analysis – Analyze operating cash flow, investing cash flow, financing cash flow, and cash flow ratios.
- Analyzing Financial Efficiency Cash Flow Drivers – Use profitability ratios and turnover ratios to analyze a company’s cash flow drivers.
- Developing Projections – Determine the reasonableness of assumptions behind business fundamentals and swing factors.
- Personal Financial Statement Analysis – Analyze the personal financial statement and tax return in the event that you are lending directly to or seeking additional credit support from an individual.
- Company Financial Statements – Analyze the company’s financial statements and provide an overview. Obviously, a small company will have a simpler chart of accounts, while a large domestic or international corporation will be more complex.
Monitor the Relationship
In today’s competitive environment, you cannot afford to wait for your loans to be repaid and expect your clients to call you for other products and services. To have a competitive advantage in today’s market, you must continue to monitor the risk profile of your client and, at the same time, pursue opportunities to develop and expand the relationship.
A profitable relationship can quickly turn into an unprofitable one. Loan payments may be timely, but deteriorating collateral, idle equipment, or
unpaid taxes can create serious risk for you. Periodic reviews, ratings, and audits can ensure that the client is one that will create long-term profitability for your bank.
Asset quality is one of the key success factors of a financial institution. Although every bank is subject to scrutiny from state and federal regulatory agencies, most banks supplement these functions with internal monitoring.
In a recent survey of banks conducted by Exoridior, the following were determined to be critical to a successful risk management strategy:
- A quantitative risk-rating system with a wide range of grades, which includes subjective factors, such as management quality. A wider range of grades allows the bank to assign credit costs more precisely.
- An effective management information system to track credit exposure.
- Risk pricing based on required rates of return that are then used in customer sourcing.
- A business strategy that reflects a proactive role in guiding relationship managers on credit exposures in the portfolio.
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