instilling the right credit risk culture
TRANSCRIPT
INSTILLING THE RIGHT
CREDIT RISK CULTURE
IN 2015
Garrett MorrisDirector of Consulting
Sageworks
January 29, 2015
PRESENTED BY
Questions
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About Sageworks
+ Financial information company that provides credit and risk management
solutions to financial institutions
+ Data and applications used by thousands of financial institutions and
accounting firms across North America
+ Awards
+ Named to Inc. 500 list of fastest growing privately held companies in the U.S.
+ Named to Deloitte’s Technology Fast 500
+ NC Tech Awards: Excellence in Customer Service
About the Presenter
+ Garrett Morris is the director of consulting for Sageworks’ financial
institutions division. In addition to managing a team of risk management
consultants, Garrett assists financial institutions with their allowance for
loan and lease losses, loan portfolio stress testing, credit analysis, loan
review and loan administration.
+ Since joining Sageworks in 2006, Garrett has been instrumental in the
development and growth of the company’s credit risk management
solutions and has helped more than 700 financial institutions.
+ He received his bachelor’s degree from North Carolina State University.
Agenda
+ The 3 P’s
+ Policies
+ Process
+ People
+ The 12 Questions You Need to Ask
+ Credit Culture & Risk Profile
+ OCC’s Advisory Letter 97-3
+ 9 Elements
+ 5 C’s of Credit
+ 5 C’s of Data Collection
+ Takeaways
+ Appendix
+ 6 Ways to Prepare
+ Important Ratios in Cash Flow
Analysis
+ Considerations for Underwriting
+ Documentation for Underwriting
+ Lending Environment
+ Key Drivers of Cash Flow
THE 3 P’S
A bank’s first defense against excessive credit risk is the
initial credit-granting process, sound underwriting
standards, an efficient, balanced approval process, and a
competent lending staff.
- Comptroller’s Handbook, Loan Portfolio Management
The 3 P’s
12 Questions
Takeaways
3 P’s: Policies, Process, People
+ Policies
+ Sound underwriting
+ Process
+ An efficient, balanced approval process
+ People
+ A competent lending staff
The 3 P’s
12 Questions
Takeaways
Policies
+ The particular way in which something is done
+ Provide the framework for the bank’s lending activities
+ Set the standards for portfolio composition, individual credit decisions, fair
lending, and compliance management
+ Supplemented by more detailed underwriting standards, guidelines, and
procedures
Certified mail must
be delivered to X-
person
Mail/delivery requiring
signatures must be
signed by a VP
Outgoing mail to IRS
must be delivered with a
confirmation receipt
The 3 P’s
12 Questions
Takeaways
Process
+ The way of doing something
+ Establishes the lending process
+ Assigns accountability and establishes the responsibilities of the people
involved
Mail gets
delivered every
day
When the mail is
delivered, it is
sorted
The sorting is
determined by dept
and purpose for each
piece
The 3 P’s
12 Questions
Takeaways
People
+ The individuals executing the process
A competent lending and underwriting staff
The 3 P’s
12 Questions
Takeaways
3 P’s: Policies, Process, People
+ The lending staff, with the knowledge and skills, utilizing various tools, arrive
at quality loan decisions
PolicyProvide the framework for
the institution’s lending activities. Sets the
underwriting standards for the credit decisions
ProcessPolicy establishes
the lending process and the
responsibilities of the people
PeopleThe
individuals executing the
process TrainingKnowledge/ skills
required to execute the process and use a
procedure
ToolsThe tools used in
the execution of the process
The 3 P’s
12 Questions
Takeaways
THE 12 QUESTIONS
YOU NEED TO ASK
Credit Culture and Risk Profile
Understanding the credit culture and the risk profile of the
bank is central to successful loan portfolio management.
Because of the significance of a bank’s lending activities, the
influence of the credit culture frequently extends to other bank
activities.
A bank’s credit culture is the sum of its credit values, beliefs,
and behaviors.
- Comptroller’s Handbook, Loan Portfolio Management
The 3 P’s
12 Questions
Takeaways
1997, the OCC’s Advisory Letter 97-3
+ The nine elements are:
+ Assessment of the credit culture
+ Portfolio objectives and risk tolerance limits
+ Management information systems
+ Portfolio segmentation and risk diversification objectives
+ Analysis of loans originated by other lenders
+ Aggregate policy and underwriting exception systems
+ Stress testing portfolios
+ Independent and effective control functions
+ Analysis of portfolio risk/reward tradeoffs
- Comptroller’s Handbook, Loan Portfolio Management
The 3 P’s
12 Questions
Takeaways
Daniel Kahneman
The checklist should be used
when the decisions are “both
important and recurring, and so
justify a formal process.”1
Kahneman, D. (2011). Thinking Fast and Slow.
The 3 P’s
12 Questions
Takeaways
The 12 Questions you NEED to ask
1. Is there a reason to suspect motivated errors, or errors, driven by the self-
interest of the recommending team?
2. Have the people making the recommendation fallen in love with it?
3. Were there dissenting opinions within the recommending team?
4. Could the diagnosis of the situation be overly influenced by the salient
analogies?
5. Have credible alternatives been considered?
6. If you had to make a decision again in a year, what information would you
want, and can you get it now?
The 3 P’s
12 Questions
Takeaways
Credit Risk Modeling
+ Determining risk factors
+ Understanding credit quality
(risk grading/risk rating)
+ Likelihood that a business/borrower/relationship may default on its
financial obligations
+ Model should account for different types of loans as well as industries
(different industries require different capital structures)
5 C’s OF CREDIT
The 3 P’s
12 Questions
Takeaways
5 C’s of Credit
+ Capacity
+ Can the borrower generate adequate cash to repay the loan?
+ Capital
+ Is the borrower adequately capitalized within industry standards to withstand
unexpected loss?
+ Conditions
+ Is the borrower flexible enough to adapt: economic, industry, and market
environment?
+ Collateral
+ Is there an alternative source of repayment in case the primary source fails?
+ Character
+ Is management willing to EAT RAMEN NOODLES if needed to repay the loan?
The 3 P’s
12 Questions
Takeaways
Credit Risk Modeling:
Financial Statement and Trend Analysis
Trend Analysis
+ Companies rarely
remain in a static
condition
+ Cash flow cannot be the
only determinant
+ Credit Analysis is much
too complex to rely on
just a single indicator
A look at the trend is critical in determining if the
business in growing or deteriorating. 0
100
200
300
400
500
600
700
2007 2008 2009 2010 2011 2012
Thousands of Dollars
Growing Business
DeterioratingBusiness
Today’s loan is repaid with tomorrow’s cash
The 3 P’s
12 Questions
Takeaways
The 12 Questions you NEED to ask
7. Do you know where the numbers came from?
8. Can you see the halo effect?
9. Are the people making the recommendation overlay attached to the past
decisions?
10. Is the base case overly optimistic?
11. Is the worst case bad enough?
12. Is the recommending team overly cautious?
The 3 P’s
12 Questions
Takeaways
5 C’s of Data Collection
+ Caliber
+ Refers to the quality of the financials provided. What types of financials?
+ Audits, Tax Returns, Reviews, Company prepared, Compilations
+ Complete
+ Are all of the forms / schedules present? Did the borrower provide debt schedules?
+ Consistent
+ Are the financials consistent? Did the borrower provide compilations one year and
tax returns another year?
+ Current
+ Did the borrower provide the most recent financials?
+ Conversation
+ Conversations with the borrower(s) help to cover those gaps in information as well
as provide supplemental explanation or lend additional insight
The 3 P’s
12 Questions
Takeaways
The 12 Questions you NEED to ask
1. Is there a reason to suspect motivated errors, or errors, driven by the self-interest
of the recommending team?
2. Have the people making the recommendation fallen in love with it?
3. Were there dissenting opinions within the recommending team?
4. Could the diagnosis of the situation be overly influenced by the salient analogies?
5. Have credible alternatives been considered?
6. If you had to make a decision again in a year, what information would you want,
and can you get it now?
7. Do you know where the numbers came from?
8. Can you see the halo effect?
9. Are the people making the recommendation overlay attached to the past
decisions?
10. Is the base case overly optimistic?
11. Is the worst case bad enough?
12. Is the recommending team overly cautious?
The 3 P’s
12 Questions
Takeaways
TAKEAWAYS
Takeaways
+ Risk averse (risk avoiding)
+ Risk neutral
+ Risk loving (risk seeking)
The 3 P’s
12 Questions
Takeaways
Takeaways
+ “There are known knowns; these are
the things that we know that we know.
+ There are known unknowns; that is to
say, there are things that we now know
we don’t know.
+ But there are also unknown
unknowns—there are things we do not
know we don’t know.”
— Donald Rumsfeld, United States Secretary of
Defense (2000 – 2006)
The 3 P’s
12 Questions
Takeaways
http://firstlinesecurities.com/from-risk-averse-to-risk-aware-part-one/
Takeaways
+ Risk and uncertainty are often confused with each other, probably
because they are related concepts. You can’t have risk without
uncertainty.
+ To paraphrase in Rumsfeldian terms, risk is the known (and quantifiable)
unknown while uncertainty is the unknown (and unquantifiable) unknown.
+ Lastly, risk and uncertainty are not static, but are dynamic and tend to
fluctuate over time. Some risks fluctuate more than others, but there is
always some degree of fluctuation.
+ Therefore, it is important to realize that there is always uncertainty, and
therefore that there is always risk.
The 3 P’s
12 Questions
Takeaways
Takeaways
Process over outcome
+ “Looking at portfolios, think deeply about process
over outcome.”
+ “If you do something the right way enough times,
you will win.”
– Dan Loeb, founder of Third Point LLC, a hedge fund with
average annual returns of 25% since 1995
+ Good decision making is not just a function of
IQ, expertise, or experience
The 3 P’s
12 Questions
Takeaways
http://firstlinesecurities.com/from-risk-averse-to-risk-aware-part-one/
2015 Risk Management Summit
+ ALLL and stress testing focus
+ More information: sageworks.com/summit
Questions and Contact Info
Garrett MorrisDirector of Consulting
Sageworks
866.603.7029
LinkedIn Groups+ ALLL Forum for Bankers
+ Commercial Credit Risk Professionals
Website+ www.sageworksanalyst.com
+ Whitepapers, webinars, thought leadership
APPENDIX
6 Ways to Prepare
1. Re-evaluate concentration limits and risk appetite
2. Review underwriting policies
3. Train personnel, the board
4. Invest in technologies
5. Hire appropriately
6. Look outside the institution (potentially)
Considerations for Underwriting
+ Understanding financial statements and the significance of the ratios requires
both skill and time.
+ Concentrate on the key aspects of liquidity, leverage, and cash flow, using
ratios, trends, and industry analysis to study them
+ Translate financial numbers into meaningful assessments of company’s
financial performance
+ Tackle these complex sets of information, condense the information into
digestible chunks
+ Utilize software, such as the Sageworks Credit Analysis solution
+ To input the information, to spread it into a consistent and standard format,
and generate an analysis of the ratios
Documentation for Underwriting
3. Loan structure information
Loan terms, including tenor and
repayment structure
Pricing information, including
relationship profitability data
4. Loan agreement
Covenants and requirements for
future submission of financial data
Exceptions to policy and
underwriting guidelines
Promissory notes, note guarantees
5. Supplemental Information
Information fields to capture data for
concentration reporting, identifying
SNCs (shared national credits) etc.
Risk rating or recommended risk
rating
1. Financial information – used to establish repayment capacity
A. Business financials
Current and historical income data, balance sheet
Balance sheet, income and cash flow projections
Comparative industry data when appropriate
B. Guarantor financials
Guarantor support and related financial information
Summary of borrower and affiliated credit relationships
2. Collateral identification and valuation
Collateral agreements and appraisals
Lending Environment
C&I loan competition intense and increasing
C&I and loan underwriting standards easing
Net easing for 8 consecutive quarters
CRE lending standards easing, but credit
supply relatively tightened in 2012
C&I loan rate spreads decreasing
60% of bankers surveyed report ↓ spreads
for loans to larger businesses
46% of bankers surveyed report ↓ spreads
for loans to small businesses
Regulatory authorities increasing exam scrutiny
of C&I lending practices
Important Ratios in Cash Flow Analysis
Efficiency ratios
The speed at which the
company can generate
cash
Accounts Receivables
days
Accounts Payables days
Inventory Days
Profitability ratios
Measure the rates of return
of investment
Gross Profit
Gross Profit Margin
Revenue Measures
Operational efficiency
Sales (Revenue Growth)
S, G, & A (Overhead)
Gross Margin
Capital Expenditures
Liquidity ratios
How quickly assets can be converted into cash
Current ratio
Quick ratio
Working capital
Leverage ratios
Managing the debt
Debt service coverage
Interest coverage ratio
Debt to Equity Ratio
Key Drivers of Cash Flow
Sales (Revenue Growth)All sales and revenues for the company
Top Line
Sales = the ULTIMATE driver of Cash
Gross MarginThe costs of producing those sales
Gross Margin = Gross Profit / Sales
Gross Profit = Sales – Costs of Goods
Sold (COGS)
How is this related to Net Profit? Bottom Line
…a measure of
whether or not a
business has
enough
resources to
pay its short-
term debts over
the next 12
months
Current Ratio
= Current Assets /
Current Liabilities
Working CapitalQuick Ratio
…a measure of
the readily
liquid assets
…a measure of
whether a
company has
enough short term
assets to cover
operations and its
short term debts
= Cash & AR /
Current Liabilities= Current Assets -
Current Liabilities
Capital Expenditure (CAPEX)
The money a company
spends to buy or upgrade
major assets, such as
buildings and factories.
Expenditures required to
maintain existing plant and
equipment. Expenditures that
produce new revenues
Key Drivers of Cash Flow: Leverage Ratios
+ Debt Service Coverage Ratio
+ The ratio of cash available for debt service (principal, interest, lease payments)
+ Interest Coverage Ratio
+ To measure if the company can pay interest on outstanding debt
+ Debt to Equity Ratio
+ Measures what proportion of equity and debt a company is using to finance its assets