For better coordination between the origination and credit risk management teams, banks need to adopt an event-driven management approach for underwriting.
A perennial issue in commercial lending is that the underwriting process seems to defy attempts at systematization. Inevitably, it seems, contingencies get the best of procedure in a complex business that depends on fast-paced negotiations between clients, relationship managers and internal decision-makers. Can the chaos be tamed?
Urgency is rising to address the issue. Commercial banks are essentially running in place right now, with loan growth being undercut by shrinking margins. As of the fourth quarter of 2014, commercial loan spreads had fallen by 100 basis points from their post-recession peak. There is a pressing need to streamline the customer experience to capture share in an intense market. Taming internal complexity is essential to progress.
Commercial banks also know they need to protect themselves by tightly managing credit standards and risk-adjusted returns. The regulatory community is hammering on this issue as well, insisting on a more cohesive and better-documented process for credit origination and management. The Office of the Comptroller of the Currency, for example, is circulating proposed guidelines for a risk governance framework that requires banks to maintain “three lines of defense” that directly apply to commercial lending, including front line sales, credit risk management and internal audit.
Perhaps hitting closer to home for executive teams, precious time is being chewed up in endless micro-discussions about deals. Managers are not managing a process. Rather, contingencies are managing the managers. Sales productivity and customer responsiveness are compromised as attention is diverted to the details.
To cut through this mess, some banks are adopting an event-driven management approach that introduces standards and streamlining techniques for major aspects of the underwriting decision-making process. These “credit events” include formal and informal staff interactions in meetings, reviews and conversations.
The goal is to clarify and expedite the major decision-making categories in the commercial deal pipeline, including portfolio fit, deal structure and deal approval. The ongoing review process for outstanding loans and lines of credit also needs to be cleaned up. Myriad contingencies will continue because that is the nature of the business, but an effective decision framework can make a big difference in dealing with the crush (Figure 1: Balancing the Workload for Credit Approval).
Each commercial banking team will have its own set of war stories about fractured underwriting decision-making processes, but here are two disguised examples that speak to common challenges across the industry:
Deal proposal. In one instance, a seasoned commercial banker independently advanced a client conversation to the deal proposal stage, going so far as to work up a full loan presentation. The banker put his skills to work in structuring proposed deal terms of mutual benefit to the client and the bank, assuming that the energy sector credit likely would meet the institution’s portfolio criteria (at least based on career experience).
The banker was crushed, however, when the deal was shot down during the first conversation with a senior leader in the credit organization. Though the proposal was solid, the banker had proceeded unaware that the bank had already reached its self-imposed portfolio limit on energy sector concentration. The credit officer was disappointed to see the fruitless investment of time, and meanwhile the banker was blindsided by the portfolio constraint and embarrassed in front of the prospective client.
Viewing the incident in terms of credit events, the problem began with poor management communication on portfolio fit, which left the banker to over-rely on word-of-mouth information and personal experience. Even after the failure to proactively convey screening criteria, there still should have been a process-related safety net in the form of routine early banker communication with the credit team. With the benefit of an early conversation, the banker could have tabled the deal and moved on to other things.
From the regulatory perspective, incidents such as this highlight the need for front-line sales teams to “own the risks associated with their activities” and act as a strong first line of defense. Bankers are understandably focused on growing portfolios to meet performance objectives but must become more cognizant of managing the risk profile of the line of business as well. The early involvement of credit risk management is crucial in heading off deals that fall outside the credit parameters of the institution.
Credit approval. At another bank, an overloaded senior executive decided to review her meeting calendar to understand where her time was going. It quickly became apparent that her office had become a lobbying destination for bankers wanting to pre-sell their individual deals before presentation to the credit committee. She asked around and heard similar stories from other members of the management team.
The upshot was that the formal credit committee meeting had largely become a rubber stamp exercise, with most discussion occurring beforehand in office-to-office side meetings. Bankers were tending to shop their loan presentations with direct managers and every single member of the credit committee as well — an enormous diversion of time, both for management and for banking officers.
Viewing the incident in terms of credit events, the core issue was that the commercial bank’s credit approval process was ill-defined. Absent a clear and consistent procedure, relationship managers fell back on the obvious, which was promoting their individual projects. Amid the disorder, efforts to systematically balance risk and client responsiveness were being compromised.
Again from the regulatory perspective, the situation speaks to the second line of defense — independent risk management. Splintered talks and deal “pre-selling” can detract from objective evaluation. In fact, regulators questioned this institution, wondering why nearly all deals reviewed by credit committee were ultimately approved.
Along with objectivity in risk evaluation, structured credit events help to support transparency in decision-making, so that both regulators and front-line bankers can see consistent, understandable patterns in deal acceptance and rejection. This helps to maintain rapport with the sales team through the ups and downs of credit evaluation.
Credit Event Framework
To properly organize the underwriting and credit management process, it is necessary to carefully map out the major types of events that drive it. This includes the people involved in the decision-making chain; the right sequence of activities; and the types of documentation required at various stages.
The logic may sound obvious. But the push from the origination side is so strong that deal preparations often reach an advanced state before the credit risk management team is brought into the loop. The answer is to reorient the workflow along four dimensions — fit, structure, approval and review — specifying the collaboration between the origination and credit teams that will be needed at each stage (Figure 2: Credit Event Framework).
Fit. An early review of portfolio fit allows the team to get a collective jump start on promising deals while minimizing wasted effort on proposals that are “outside the strike zone.” The discovery starts with client financial statements, basic company information, industry data and preliminary spread estimates supplied by a credit analyst.
In a discussion of portfolio fit, the relationship manager will typically review the client’s qualitative and financial profile, going from there to sketch out a preliminary deal structure with the direct manager. The focus is on making a yes/no determination of whether to proceed in developing a term sheet. Senior leaders are brought in as needed depending on the client or deal magnitude.
Structure. With a go-ahead on the basis of fit, structure-related questions begin with a fuller review of client needs and preferences, plus a collective evaluation of how the working proposal aligns with the bank’s credit criteria. The objective in this phase is to craft a balanced term sheet that will meet hurdle rates of return, protect the bank from downside risk and win internal approval, ready for delivery to the client.
Approval. The preliminary approval meeting includes the relationship manager, senior bankers and credit staff, and it culminates in the release of the term sheet to the client. Upon client approval, a formal internal loan presentation is prepared. The formal approval meeting includes a deeper evaluation of the company’s financial condition and underwriting considerations. Once the credit terms are finalized, the client is notified and legal documentation commences.
Review. The credit team continues its involvement with outstanding loans and lines of credit via periodic reviews, either quarterly or annually depending on the type of facility. Updated client financial information typically is required for these meetings, and risk factors are recalculated to ensure a continuing fit within the original credit terms. The review process also extends to renewals, although the level of required effort typically is lower since the institution already has complete customer information.
Again from a regulatory perspective, periodic reviews can accomplish many of the best practices prescribed for the third line of defense, even though they are not conducted by an internal audit group. Once a uniform review structure is in place, the internal audit group can monitor the process, helping to quickly identify and mitigate risk. A robust review process also encourages strong data governance, given requirements to update customer financial data and risk profiles at regular intervals.
Across all of the credit event dimensions — fit, structure, approval and review — each of the three regulatory lines of defense must work in tandem to balance the return on the portfolio with the credit risk appetite of the institution. Left untended, weak governance practices will inevitably lead to lapses in credit risk management, with potentially severe consequences, both regulatory and financial.
While credit events need to be well-defined, this does not imply an underwriting straightjacket, as both RMs and the credit staff need flexibility in responding to the unique requirements of each transaction.
Banks tend to veer to the extreme, either imposing a restrictive, one-size-fits-all process or having little apparent structure at all. The key is to find a happy medium, tailoring process and documentation standards for major deal types, sizes and lines of business, supported by a general framework.
Well-structured credit events provide three main benefits:
Improved customer experience. Promising opportunities can all too easily evaporate in the face of long cycle times, miscommunication on key aspects of a negotiation, or unsatisfactory dealings with individual bankers. Structured events provide a common foundation for the origination and credit teams, permitting deal creativity and quick responsiveness while protecting underwriting standards.
Risk/growth balance. Structured credit events facilitate the proactive co-involvement of the origination and underwriting teams. Often today, growth is emphasized at the expense of the formal review process. In the future the two factors must be much better balanced, with credit risk screening providing a more timely and effective line of defense.
Regulatory compliance. Commercial banks are experiencing new levels of regulatory scrutiny and compliance pressure, as reflected in the OCC’s three lines of defense and in stress-testing prescribed by the Fed’s Comprehensive Capital Analysis and Review (CCAR) and the Dodd-Frank Act Stress Test (DFAST). Strong data management is critical in compiling the more lengthy internal data series, generating more the more detailed credit loss analytics, and drafting the more thorough documentation that regulators are requiring.
Credit events provide an audit trail for each transaction and assure data capture by specifying required inputs and outputs at each stage in the process. They also provide a new level of process transparency, valuable for executive management, business line management, risk management, compliance, audit and financial management.
Quest for Clarity
There is no single solution for implementing efficient and effective credit events. Organizational styles differ, for example, with some institutions placing a heavy emphasis on credit committee approval, and others using signature approval for the vast majority of loans. Each bank will need to clarify the processes that will best support its preferred approach, and then follow through with a determined effort to instill the appropriate credit event standards into the origination and underwriting workflow.
One requirement is constant across banks, however, which is that the framework for credit events needs to be well-defined. This is essential in streamlining origination, underwriting and portfolio management processes for improved customer responsiveness in an intense market; protecting the risk profile; and meeting regulatory expectations.
Michael Rice is a Managing Director, Chevy Marchosky is a Principal and David Zwickl is a Manager in the Chicago office of Novantas Inc. They can be reached at firstname.lastname@example.org, email@example.com and firstname.lastname@example.org.